Intro. [Recording date: March 20, 2017.]
Russ Roberts: So, I want to start with the rise of the financial sector which is one of the themes of your book, Makers and Takers. And I want to start with, you say, "How did finance, a sector that makes up 7 percent of the economy and creates only 4 percent of all jobs, come to generate almost a third of all corporate profits in America at the height of the housing boom, up from some 10 percent of the slice it was taking twenty-five years ago?" So, why is this so alarming? And what does it tell us?
Rana Foroohar: Well, I would start by saying, the financial sector or financial services--and I stress the word 'services' because that's kind of the key point here: finance used to be service to the real economy and service to business--it used to function basically as an intermediary. You know, greasing the wheels of Main Street capitalism. But what I'm arguing in this book is that in the last 40 years or so, we've had a fundamental shift, in two ways: In the role of the financial services sector in our economy has now become sort of the tail that wags the dog--which I can explain a little bit more about; but also in terms of size. So, those numbers that you quoted before--7% of GDP (Gross Domestic Product), 4% of jobs, but a quarter of all corporate profits--that is a big, big shift. If you go back to the 1970s, finance was about half the size, in terms of U.S. GDP as it is today. It was playing much more of a sort of capital allocation role rather than a trading role. So, it was essentially helping do what Adam Smith thought it should do--which is take all of our savings, in the form of bank deposits and lend them out to Main Street businesses, to the real economy. Which would then create growth and jobs. I'm arguing that today the financial services sector, and you know I have a lot of deep research in the book to back this up, has become the game in and of itself. Only about 15% of all of the capital coming out of the biggest U.S. financial institutions today goes into business--goes on to Main Street. The rest of it is basically about the buying and selling of existing assets, which brews bubbles, which creates instability in the system; and also creates a kind of a perverse cycle in many ways, in many deep ways, where we are all oriented towards the financial markets--via our 401ks or if you are a CEO (Chief Financial Officer) trying to jack up the share price of a company--it's all about policing the markets. It's all about the short term. And I'm arguing that that's had a very deep and degrading effect on the real economy in America.
Russ Roberts: So, only 15%, you suggest, goes to "real projects," or real investment rather than moving stuff around--pieces of paper, speculation, trading, and so on. Of course, this is much bigger than it used to be, so 15% of a much bigger number can still be a good number. The real question that I worry about, and I think you worry about also, is the rest of it: What is going on there? And the industry would defend itself by saying that they have created all these new instruments--derivatives and other things--yes, sometimes blow up, but that are useful in helping people create the portfolio that best matches their risk preferences. How do you respond? That's the argument. I'm, you know, they've to tell a story. Right--
Rana Foroohar: We've all got our narrative, right?
Russ Roberts: Right. So, what's wrong with that narrative? Do you think there's some truth to it? Or, do you find it just self-serving?
Rana Foroohar: Sure. So, let me take that in pieces. Let me first go to this 15%, which is an important number. This, by the way, is based on very deep, long-term academic research that was done by Alan Taylor, who used to be with Morgan Stanley, now at Berkeley; and Moritz Schularick, who is a European academic. It was funded by INET [Institute for New Economic Thinking], which is kind of, as you probably know, a liberal-leaning think tank that's dedicated to kind of getting new economic ideas out there. And basically, what they're looking at is the amount of investment that goes into business. Into real businesses that create real products. And that's only 15%. Now, and yes, that's true that it is a much larger number than it was in the 1970s. But, to your point: What's the rest of it doing? Well, that 85% that's left over is the trading of existing assets: Stocks, bonds, and housing. And there is a lot of research from big institutions--the BIS (Bank for International Settlements), the IMF (International Monetary Fund), the World Bank, any number of academics--that show that all of that trading has questionable economic value on a kind of a global net basis. It certainly has not generated real economic growth. If you look at the growth of finance, you find that it tends to stifle economies when it's even half the size that it is in the United States right now. On the other hand, there's also a lot of research to show that excess trading creates bubbles, creates market volatility. I mean, you know, there's plenty of academic research I can cite but we can also just go back to our own memories of 2008: we sort of know how this works. But, to your point about derivatives and risk allocation: This is a really, really interesting question. And in fact one of my favorite chapters in my book is a chapter that looks at this very question. I have a chapter on derivatives trading and in particular commodities and derivatives trading. And, you know, I spoke to some great sources on this: Gary Gensler, who used to be head of the CFTC (Commodity Futures Trading Commission) was a big source on that chapter. And I looked at the story, that I'm sure many listeners will remember from a few years back about the run-up in aluminum prices, globally. You know, there was a wonderful front page story on the New York Times, I think really encapsulated it for a lot of people, looking at how Goldman-Sachs had become a large owner of aluminum. And was getting around loopholes about the fact that you can't sit on a lot of raw commodities and trade them at the same time. You know, you have to kind of move them out of warehouses, the idea is that this, um, prevents banks like Goldman from actually owning and trading and thus cornering and thus manipulating the market in certain raw commodities. Well, the bank was getting around this by literally kind of forklifting aluminum from one warehouse and moving it, you know, 16 feet to the other one. And it was just a really wonderful visual of how perverted the entire market in this particular area of commodities, derivatives, trading, and ownership had become. And, you know, there are numbers that show that, Yes, of course derivatives trading is useful for people that own raw commodities. People like farmers. You know. And derivatives have been used since ancient Greek times. You know, the idea of an option on oil, or, excuse me, on an olive oil press was something that was talked about way back when. That's all well and good. But the problem is that today, the derivatives market itself is an exponential factor larger than the value of the underlying commodities that it's supposed to be insuring against. So, many people, many academics--which I quote heavily in this chapter--would say, 'Look, when you've got a market in trading that is--' I couldn't say that it is at this very moment, but, '25, 30, 50 times the value of the underlying product that is being insured, something's going on that has nothing to do with the real economy.' You know. And there have been any number of traders that I've spoken to that say the same thing, that: Look, you know, hedging is a business. It is no longer necessarily or in large part about actually protecting the value of an underlying commodity. It's about making a profit. And one of the things that is particularly tricky--and I know I'm getting a little bit into the weeds here but I think it's useful for people to understand--there used to be legislation that protected the consumers in the marketplace from market manipulation in the sense that someone who was doing a lot of trading or primarily being a trader or a market maker couldn't actually own a lot of physical commodities. That has now changed. Banks lobbied against that rule, many years ago. And so now you have huge institutions that can both own a physical commodity and trade it for profit. Which is kind of the essence of market manipulation. And that's why this chapter looks at how companies like Coke and Coors, and, you know, the people that actually need aluminum to make their products were complaining that, 'Hey, why is Goldman-Sachs manipulating, cornering the market, in this product?' By the way, I should say that this whole incident was looked into by regulators, and the bank was not found guilty of any misdoing, but again, you know, experts would say it's very, very difficult to tease out what is about hedging your portfolio for legitimate reasons and what is about speculation and market manipulation. And I think anybody who takes a look at this chapter will be surprised, you know, to see how close those two things can be.
Russ Roberts: You know, I wasn't convinced by it. I thought it was interesting. I hadn't followed the incident and the discussion when it happened in real time. And I think--you raise a lot of points. There were a lot of interesting thoughts there. You know, one of them is the size of the derivative market relative to the underlying product. Sounds bad. It's weird. But I think the fundamental issue is, you know, what are the incentives, and how competitive are these markets? And of course some of them are not so competitive. We're going to come to that later when we come to regulation and the size, the concentration of the banking sector. I want to talk about that later. But I think in this particular case, I looked at the data--we'll put up links to that--your New York Times story and some subsequent analyses. It looks to me like aluminum actually fell--the price of aluminum actually fell during a large part of this claim when Goldman was manipulating the market. And listeners to the program know I'm not a big fan of Goldman-Sachs. So, I'm not--it's not a--for me--part of me wishes it were otherwise, and obviously reasonable people can disagree on this. But I think the fundamental question is competitiveness: How many firms can get access to this? And the stupidity of making firms move stuff around with forklifts--that's--we probably agree on that.
Rana Foroohar: Well, it's interesting. Let me jump in and say for starters, it's really important on the aluminum question. I quoted Michael Masters, who himself was a trader--was one of the people who came out and said, 'Hey, this is--it's not right, what's happening in the derivatives market.' And he had Senate testimony that you might want to link to as well, which is fascinating. But one of the reasons that Goldman and the other banks got out of aluminum is that, guess what? It was a good time to get out of aluminum, for a couple of reasons. One, the hot money that had come into the emerging markets and the commodities markets, which often are a play on the emerging markets--and that had come, by the way, you know, P.S., because of the Fed pumping $4 trillion dollars of money into markets thanks to the financial crisis--we can talk about that and financialization as well. But, um, they got out of the aluminum market in part because that bubble was peaking and starting to decline. And, the Fed had also announced that it was going to start looking at this rule about whether traders could actually own physical commodities. And so it was a--it was a good time to get out. But, per your point about regulation: There is still nothing that would prevent a bank, a financial entity from getting back into these markets. Bidding them up. And doing things that are actually a bigger deal than just making, you know, the price of a six-pack more expensive. Doing things like making it hard for people to eat. You know, Josette Sheeran, who was the head of the World Food Programme during the commodities run-up that I write about in my book--you know, used to go around Davos with a red cup that held a day's worth of grain that she was feeding through the World Food Programme, and she said, you know, she would pour out half of it and say, 'That's how much speculators are literally taking out of the mouths of children.' So I got to push back and say: I think that speculation is a huge deal in commodities. And even if we are not at the top of a cycle, it doesn't mean we can't be back there again. But, let's talk about regulation, because I think that that's not an interesting topic.
Russ Roberts: Yeah. I just think that--speculation is--the world is a complicated place. And the opportunity as you point out to hedge against future uncertainty has been comforting to a lot of farmers and a lot of folks, that worry--
Rana Foroohar: Absolutely, they should be allowed to do that. But I think that we need to have a rule come back onto the books that institutions that are primarily trading should not be owning large amounts of physical commodities. But anyway, that's--we can move on, if you'd like.
Russ Roberts: Yeah, let's move on. The bigger issue--you alluded to the fact that the size, there have been some studies that the size of the financial sector, it's too big in terms of growth. And you talked in your book about how the financial sector reduces growth--the size of it. I've seen equally general studies, and these kind of studies are inevitably--I don't trust any of them, actually--that have shown that the bigger the financial sector, the bigger the growth. And these are just--I think this is kind of a bad exercise. I think the question is: What are the incentives that the financial sector faces that are healthy and what are unhealthy? And I think those are the issues. So, let's take one of the ones that comes up in your book: the seeming, the lack of investment that's going on in the American economy today--the stockpiling of cash, the use of that cash for stock buybacks. So, you are alarmed by that. I am, too, but I think for different reasons. So talk about what's worrisome to you about it.
Rana Foroohar: Okay. So, this is a really complicated issue. There are sort of two things in play. There's the size of the financial sector and how it's grown over the last 40 years. And, by the way, let me caveat that there have been many periods over several hundred years of the growth and the diminishment of the financial sector, so I kind of took the most recent one because it's just the easiest one to look at; but this has all happened before. So, there's that. And then there's: What is the role of the corporation? Is the role of the corporation to simply please the shareholder? The kind of current debate over shareholder value and whether the stock price of a company is the best indicator of its underlying value? Or is the role of the company something else? Is it to please a larger group of stakeholders, not just shareholders but workers, consumers, the community at large, regional economic ecosystems? And I would say that, you know, in the United States of course we have basically shareholder capitalism, which a lot of people even within the financial sector are starting to push back about. But in other countries and other regions, they have different forms of capitalism: you know, Europeans do it very differently; a lot of Asian state-run economies and emerging market economies do it very differently. So, this is a very live debate. Now, those two things start to interact and have a big snowball cycle over the last few decades for a couple of reasons. You talked about buybacks; and buybacks have been obviously hugely in the news in the last couple of years in part because they've reached record levels. But how do buybacks even come to be? If you go back to 1982, buybacks were actually illegal. They were considered market manipulation. Because, if you think about what a buyback is, it's when a company comes onto the market and buys back its own shares, which artificially reduces the number of shares and drives up the share price. That was considered market manipulation. But under John Shad, who was the SEC (Securities and Exchange Commission) Director under Reagan, that was changed. And so companies were now allowed to do that. You start to see immediately at that point in the 1980s a big uptick in the number of buybacks. And you also start to see the money within corporations being funneled much more into the financial markets via those buybacks. And you start to see the amount of R&D (Research and Development) spending as a percentage of revenue--which would be another place that that capital could go--start to taper off. Okay, so you come to the 1990s then: Bill Clinton is in office. Bob Rubin is Treasury Secretary. You've got Larry Summers. You've got a bunch of kind of financially friendly folks in charge. And there's another debate that starts to happen in the 1990s about wealth inequality and the financial markets and whether or not they are actually helping society in a productive way. And there were other folks in the Clinton Administration, like Joe Stiglitz, at the time--the progressive, who were arguing, 'Well, the wealth cap is getting really big here, and we know financial markets have something to do about that. We see that there's a lot of corporate compensation that's being paid out in share options. That's an issue.' And so Stiglitz and some others argued for a cap on corporate pay. But certain other factions in the Administration, the kind of Rubin camp, argued, 'No, we should have a cap on corporate pay, but we should be able to have performance-based pay for top performers that would be paid out in share options.' And so that was allowed, above $1 million. And, by the way, this was a very bi-partisan issue, because, you know, not only were certain Democrats in favor of this, but a lot of Silicon Valley tech money--you know, CEOs--were lobbying for this, because obviously a lot of their compensation was tied to share options. So that was passed--
Russ Roberts: It seems like a good idea: to [?]--
Rana Foroohar: Yeah. Yeah. None of this--nobody's being venal here. This is about trying out different things and seeing if they work. And you can see the argument for paying someone share options. Absolutely. But what happens, then--and if you look at the data in the book, you then get a huge uptick in the amount of share buybacks that are being done. You start to see huge amounts of options pay coming onto balance sheets, much of it in tax-favorable ways, which is a whole 'nother thing that we may want to take about--the tax code and how that plays into things. But you really start to see that performance-based pay taking off. You see wealth inequality starting to grow dramatically. And Thomas Piketty gets into some of this in his book, Capital in the 21st Century and how stock options and performance pay figured into wealth inequality. That, of course, has, I believe, a dampening effect on the overall economy because there's only so many cars and houses and pairs of jeans that, you know, rich people can buy. We can, again, talk about that. But what you really start to see then is that that share options number goes way up and investment into R&D as a percentage of revenue starts to go down. Now, I will say that actual causal links are very, very difficult to make in this equation. Right? Because there's a lot of things--as you mention, the financial markets are a complicated place. There's a lot of things happening. But there are plenty of people--academics, but also CEOs, folks in finance themselves, who would say, 'Yeah. A lot of the buyback money that's in the markets right now is going there because executives make these decisions. They get 80% of their pay in share options. They have every reason to jack up the share price quarter-on-quarter. The Street demands that they do that or they are out. The average tenure of a CEO is 3 years; and you have to be a founder, owner, an entrepreneur--somebody with a big personality to really fight against that pressure. And so you get this snowball cycle where I would argue that the markets are no longer effectively funneling capital to places where it is necessarily the most productive. They are funneling it to a place where it enriches the closed loop of the financial markets itself.
Russ Roberts: Well, I don't think there's anything sinister--I don't see it as particularly sinister--
Rana Foroohar: It's not sinister. It's incentives.
Russ Roberts: Yeah; I'm not sure how important the incentives are. But they are relevant. And it's certainly true that CEOs have an incentive to buy back stock rather than give a dividend. Both of them are ways to return money to shareholders--who choose--in the case of a dividend, everybody gets the money. Every shareholder gets the money. In the case of a stock buyback, if you want to take the cash, you can then sell some of your shares and cash out, and take the capital gain--which, if it's a long-term gain it's going to be the same tax consequence as the dividend. But, to me, the bigger issue is: Why aren't they investing more? And that fundamental question is, of course, complicated. It depends on--
Rana Foroohar: Well, not so complicated. I mean, you know, one of the things I look at in my book--I have a lot on Apple because Apple is such a great mirror into this whole thing. Every time--first of all, Apple hasn't needed to raise money for operating expenses since the 1990s.
Russ Roberts: A lot of cash--
Rana Foroohar: In cash. Sorry. Yeah. Every time that company, or frankly any company, says, 'You know what? We're going to make a big, long-term R&D investment', the share price goes down. When they say, 'Hey, we're going to do buybacks and dividend payments to, you know, bolster the quarter,' the share price goes up. It's really not that complicated. Short term [?] rules.
Russ Roberts: Yeah, I'm not sure that's true. The reason I say that is that, Apple--
Rana Foroohar: Yeah, it is true. No--I actually document it in the book. It's well-footnoted.
Russ Roberts: That's not necessarily the same as undeniably true. I think the question for Apple is: Apple made a lot of investments. A huge amount of R&D investment over the last 25 years. Some of those were incredible. Lately they haven't been doing so well. So, they're hit rate, their success rate, is down. They seem to have lost some of their innovative mojo. So I'm not surprised that their market is not as enthusiastic about them as they once were.
Rana Foroohar: Well, but that kind of proves my point. I mean, the whole first chapter of my book is about how different the management of Apple was under Steve Jobs versus Tim Cook. You know, you are absolutely right: I mean, this used to be a company that ported a tremendous amount of money into R&D. And, you know, one of the reasons that they were able to do things like, open Apple Store--you know, open a giant glass box with 3 products--he, he, he--this is what Apple Stores were when they first opened, right? You know, if you'd been an average CEO going out to the markets saying, 'Hey, we're going to open a bunch of stores that are incredibly expensive. We're going to put three products in them.' You know, all these things that Steve Jobs did. And the markets were killing. But he was somebody that had the sort of first force of personality to push those ideas through. Tim Cook is very much I think a steward of a more developed, you know, older company. And he works in a much more financialized way. And this is a big, this is a big issue and problem. I mean, if you look, there's been some Stanford research that's been done on tech companies IPOing recently in the last 12 years or so. And you look at how their innovation starts to tail off after they go to the public markets. It's just really, really hard, once you have that pressure of the public markets, to jack up share price, to say, 'We're going to do these 5-, 7-, 10-year investments in new technologies in sort of blue-sky things that may not pay off. And they're going to be really risky. And we may even, you know, lose market share or take a hit in the short term. But we think it's going to pay off longer term.' I think it's really, really hard for companies to make those investments. And I think any CEO you talk to will say that that's true. And some of them want to; and some of them don't.
Russ Roberts: They make those investments now, in the early days of their company, spending their own money and the money of their financial capital investors who have a portfolio of 10, 20, 30 companies of which they hope a few will become unicorns worth a billion market cap or more. And they realize that most of them won't; and they can't know which ones they are in advance. And that's what that market does really well. And the stock market--the public company market--does something different. It's not surprising that it's hard to sustain brilliant innovation through the life cycle of a company. Apple is really an extraordinary story in that Steve Jobs was able to innovate more than once. Once is a huge number. But he was able to transform a number of industries through visionary investing. It's not in R&D. It's not surprising that Tim Cook can't do it. I don't think it's because Tim Cook isn't, has a different philosophy. I think Tim Cook is not as talented. And I say that with total respect for him. It's a tough standard to say you are not as talented as Steve Jobs.
Rana Foroohar: Yeah. Well, he has his strengths. But I would say that one of the things that's concerning to me is that when you look at how, who the new challenges are, globally, for big American companies, they tend to be emerging market giants or international competitors that don't have that same short-term market pressure. And I do think that makes a difference. I think that family-run emerging market companies, they can look out over 20-, 30-, 50-year horizons rather than 2-quarter horizons, are able to do things that big American multinationals aren't. And given that those companies are still the largest employers in the United States, I think that their operating environment is really important for all of us to understand.
Russ Roberts: Yeah. I agree with that. I think the deeper question--and I don't deny that there is some short-termism in U.S. companies. Part of it is a result of that--
Rana Foroohar: Ha, ha, ha--
Russ Roberts: What?
Rana Foroohar: Some. I mean, I would say that that's the fundamental driver.
Russ Roberts: Well, would you say that that's the driver in the political market as well? That politicians only care about 2 years, because they most--most representatives--
Rana Foroohar: Well, yeah. Yeah, I think I would--
Russ Roberts: are at risk of being thrown out? So--
Rana Foroohar: and that's part of it. I mean, I have a whole chapter on the interaction between Wall Street and Washington, and I want to--we can get to that.
Russ Roberts: We'll get to that. No, that's the one we agree on totally. So we're going to have fun with that one.
Russ Roberts: I'm not--what's interesting for me as a reader of your book is that I agree with about half of it. Vehemently--so, that's unusual.
Rana Foroohar: Ha, ha, ha--
Russ Roberts: Rana, I'm a Chicago-school economist, right? So, I could disagree with all of it. But I don't. I agree with a lot of it. And I think it's a fascinating time in American public policy, the last 5 years or so and going forward, where people like you and me who look at the world very differently, agree very much on this one issue: Which is that Wall Street has too much power. And Wall Street has too much influence. And Wall Street can wreak a lot of destruction outside of its boundaries. And we agree on that. And yet we disagree, sometimes, on what the other stuff is, like we're doing now, about the rest of the economy works. And we might disagree on how to make that better. We'll get to the how-to-make-it-better part, because I think fundamentally there's a difference in our diagnosis of the problem. I suspect as to why, even though we agree on that the symptoms are bad, we might disagree on the underlying disease. So, let's turn to that. One of the points you make in the book is how much credit has expanded in the United States to consumers. And that this has led to a lot of more profit for the financial sector, and you'd think it would go the other way. You'd think they would have to be competing to give consumers better deals. Talk about that and what's alarming about that; and what do you think is going on there?
Rana Foroohar: Well, so, this issue that is really important, and I look at it mainly in the tax chapter, because one of the things that I think we should be looking at in Washington is the way in which the tax code subsidizes debt. It's actually an interesting question politically, because I know some conservatives who disagree with my analysis, but I also know plenty of kind of mid-Western rust belt conservatives who actually do agree with the analysis, and think that debt is a big problem. One of the things that's fascinating to me politically is we talk about national debt but we don't talk so much about consumer and corporate debt--which, you know, can wreak a lot of havoc. So, a lot of the figures that I quote in this part of my book come from Sufi and Mian, who wrote House of Debt, which you may have read, looking at how quick run-ups in debatable kinds tends to be the biggest predictor of financial crises, right? And so, I always like, just as a financial journalist and somebody that covers business and economics, I like to look at where debt bubbles are brewing, to look for where trouble may potentially occur. And sometimes it's difficult to see how the dominoes will fall. But you could certainly in the run-up to 2008 look at the housing markets. And see debt run-ups there. I would argue that today you could look at the corporate debt markets and say, 'Okay, even though companies have a lot of cash on the balance sheets, some of it stored in overseas bank accounts, there's been a huge corporate debt bubble that's brewing.' You've already started to see some correction of that in junk bonds, particularly in commodities markets. And, what's interesting is a lot of those corrections that you've seen in the last 2 or 3 years have come when the Fed has indicated for example that it's going to pull back on quantitative easing or that we're going to start moving into a different interest rate environment. That's when you started to see a correction in some emerging markets, in some commodities markets, and also the popping of certain junk bonds, particularly minerals and manufacturing and things like that in the United States, where had seen a lot of run-up in debt. So, debt has this perverse effect. Just as a little interesting side-note: I am thinking and looking a lot at debt in China right now. And I mention that a little bit in my book; I didn't get too much into it. But if you look at where there's been a huge run-up of debt in the last few years, it's been in China, in a way that really makes Arizona or Florida housing markets seem kind of minor by comparison.
Russ Roberts: Yeah, they've got some issues coming.
Rana Foroohar: They've got some issues--in how they handle it; and what a financial crisis in a state-run and closed economy looks like is kind of another question. So, debt, as a predictor of financial crises is important. And then, the thing that I find concerning and something that I wish policy makers would look more closely at is how the United States tax code subsidizes that debt. So, I'll just give a personal example. I live in a brownstone in Park Slope, Brooklyn, which is a very hot housing market. I, like every other person in the country, enjoy a sizable tax benefit from the mortgage interest deduction. That's a deduction that benefits mainly middle- and upper-class people.
Russ Roberts: Yep.
Rana Foroohar: That is something, of course, that is a total political hot potato. But that's exactly the kind of deduction that I think we probably shouldn't be giving. I think that the housing market in my neighborhood and many others would look very different if we weren't getting that.
Russ Roberts: Totally agree.
Rana Foroohar: Same thing in commercial real estate, right? You can spread that out. There's also any numbers of ways in which we subsidize unproductive corporate debt. And you know the economists you may have read, they did a really deep dive, I don't know, maybe a year ago into this issue of tax codes subsidizing debt versus equity and what would it be like if that changed. And I'm not saying for a minute that that's not a complicated shift to make or that that wouldn't come with its own set of consequences that could have, you know, unintended implications. But it's an interesting question: Why are we subsidizing all this debt? Who is it benefiting? And one party that it benefits a lot is the financial markets, because financial markets and intermediaries issuing the debt, making money from these transactions, and so on and so forth.
Russ Roberts: Yeah. I like to say that Republicans and Democrats are very similar: They both like to give money to their friends; they just have different friends. But they have one friend in common, which is the financial sector. So that's, I think, the most dangerous piece of our political economy and public policy incentives that we face today. But you raised--the point about debt versus equity is a central question. And you talk about it in the book and focus on it, correctly, that the rise in debt finance and the increase in leverage on Wall Street is just extraordinary. And I think you correctly identify one of the causes of it, which is an important cause, which is the end of the partnership model. Which was the Wall Street model until, really, almost the late 1990s, mid-1990s. Until then, banks spent their own money. They were partnerships. You brought in--your own money was a risk, as a bank--excuse me, as an investment bank. I want to make it clear I'm not talking about Main Street banks or about Wall Street banks.
Rana Foroohar: Yeah; yeah.
Russ Roberts: That, the investment banking business was very much a partnership model. That changed. And that, to me, is really when we unleashed the most dangerous potential for disaster, which is culminated in the housing crisis. And that's because they weren't spending their own money. Their ability to borrow money got incredibly dangerous. Which made them very prone to small changes in asset prices, making them insolvent. Which is what happened. So, for me, and I want to give you my explanation--you can react to it, because you don't talk about it in the book--and I don't see a lot of people doing work on this, which is sad. Which is: Why did this change? Why did banks become publicly traded? Why did investment banks become publicly traded? My argument is, is that it once it became clear that debt holders would be protected in bailouts--which started in 1984 with Continental Illinois--
Rana Foroohar: Yeah--
Russ Roberts: and then proceeded regularly through the Mexican Crisis and elsewhere, that people who lent money would be able to get almost 100 cents back on the dollar. Almost every time. That made it incredibly costly to be a partnership, because what you should be doing is being highly leveraged, borrowing a lot of money, going into the financial market through a publicly traded company and having a lot more assets of other people to spend.
Russ Roberts: So, that's what, to me, is that big change. And so, for me--and this is naive--but my goal is to reduce the applauding of bailouts. To me, bailouts are the source of the biggest problem.
Rana Foroohar: Totally agree. Totally agree. I mean, I love this point, actually. And it's one of those interesting points that I--you know, I'm a liberal, but I'm a mid-Western liberal. My dad ran a manufacturing company; I grew up with a somewhat different idea about debt and bailouts, I think, than many liberals have. And I agree with this point. I think there is a tremendous amount of moral hazard at play here. And I, in my own research, didn't go so deep as you've just done to isolate particular cases and, you know, the legislation that led to all these changes. But I love this point. And, what I did think a lot about is the way in which the political economy and Wall Street interact. And at the end of the day, it benefits a lot of people in Washington to have large financial institutions doing their bidding. And this is something that Calomiris--and I forget the other academics--
Russ Roberts: Haber--
Rana Foroohar: Yeah, Fragile by Design--got into this idea that, you know, governments from the dawn of time want financial markets to be big and rich so that they can do things like wage wars and build railroads--and whatever it is.
Russ Roberts: And donate money to political candidates.
Rana Foroohar: Right. But that comes with all kinds of hazards. And then they end up having to bail out these kinds of institutions that they have supported and kind of gotten into bed with. And it is a really, really perverse cycle. That said, I mean, and I'm curious what you would say to this, actually--I don't know what your position on the bailouts was--I think it was tough to take a completely Malthusian argument, or Hayekian argument, however you want to put it, that you should have just let the financial markets completely collapse in 2008. I mean, what do you think about that?
Russ Roberts: Well, the problem is that once you head down that road--to me, it's kind of like saying to your kid, 'If you drink and drive, I'm going to punish you.'
Rana Foroohar: Yeah.
Russ Roberts: And so, the first time they do it, you say, 'Well, you really weren't that drunk, so I'm not going to punish you.' And then, the 15th time, it's kind of too late.
Rana Foroohar: Yeah. Yeah. I know, I hear you--
Russ Roberts: --you get a crash. And, you know, I've used this analogy many times on the program; and others have, too. It's--just--I think I invented it, but I'm not alone. Which is, the forest fire: If you put out every fire because you are afraid it's going to lead to a forest fire, a bigger fire: Eventually you allow the buildup of a fire you can't put out. And so, we bailed out--a lot of the bailouts were justified, going back to 1984. You know, they were justified: 'Well, this could be a systemic crisis.' So, we bailed them out. Or, what you talk about, Long Term Capital Management--at least they were bailed out with their own--with [?] uses some money. But they were coerced, as you point out, by the Fed, to do that. And so each time there was a--probably would have been an unpleasant but not earthshaking disaster, we made sure that everybody was given a do-over. And that eventually created a disaster that was so large that it really would have been a horrible conflagration. A horrible disaster. And so everybody felt pretty good. And my profession has unanimously, almost unanimously--I'm the exception and a few others--but almost unanimously applauded the 2008/2009 bailouts as necessary. And, well, they kind of were if--in that there probably would have been a much worse recession, maybe a real depression--at that point. But we sowed those seeds so long ago.
Rana Foroohar: Yeah.
Russ Roberts: And so the real challenge now is, 'Now what?'--
Rana Foroohar: Well, yeah-- That's where--and, yes--
Russ Roberts: We've created a concentrated banking system that's prone to a much bigger problem now, and that is going to easily say, 'Oh, you can't let us just die, because there's going to be horrible consequences.' So, I just feel like we've boxed ourselves in, in a terrible way.
Rana Foroohar: Well, I think that's a really deep and important point. As you were speaking, I was thinking about all the factors that go into this. I mean, when you think about how officials and regulators react to the markets--I mean, I was thinking about: 'What's the difference between, say, a Bill McDonough, you know, as New York Fed Chair, versus, Tim Geithner?'
Russ Roberts: Not much.
Rana Foroohar: Well, I don't know. Maybe McDonough I think might have been a little, maybe was a little tougher at some points. I think that there's a way in which because the rise of finance has led to such a revolving door between the institutions and Treasury and the Fed that there's a group of people that, I think are less like likely to personally push against the institutions at crucial times.
Russ Roberts: Absolutely.
Rana Foroohar: Yeah. So, you know, you get--at the end of the day, how does this stuff work? You know, a crisis happens. You get everybody in a room. And you say, 'You know what, guys? You're going to put your own capital up.' And you can say that in a way that makes them know that there's 10,000 levers you can use to make their lives hell if they don't. Or, you can blink. And why is that? But then there's this much, much deeper issue that you're hitting on, which is that: You know, yes, there are personalities, and the particulars of the moment, but we've been brewing this problem for decades. And how do you fix that? One of the things that I talk about in my book--I really, really don't like certain aspects of Dodd-Frank as much as I think the financial markets need to be properly regulated. I don't like the way in which we're going back and trying to post-facto predict, you know, how to prevent x-, y-, and z-type of crises, because as we know, the next one will always be different, and will come from a different place. And that's why I think we need a fundamental rethink of: What does a healthy financial system look like? You know, we need--and, by the way, we need a healthy financial--like the financial markets are so important. I feel like this is part of this debate that doesn't really get spoken about so much. It's always--and this is something I tried not to do in my book; and maybe I've failed. But I really didn't want this to be a banker-bashing book. The financial markets are the center of the capitalist system. They've got to be healthy. They've got to work properly. So, what do we want them to do? And then, how do we incentivize them to do those things rather than post-facto trying to prevent every possible bad thing that they've ever done from happening again. Which isn't going to help us with the next crisis.
Russ Roberts: Yeah. And Dodd-Frank--I mean, it's, um--I haven't read it. Which--
Rana Foroohar: You haven't read 2000 pages?
Russ Roberts: I haven't read--I have read a lot of pages of a lot of things that I didn't want to read. So, I, I confess this with some shame. I should have read it. But in a sense, one doesn't have to read it. And here's why. So let me make this claim, and let you react to it. What's clear to me about Dodd-Frank, not having read it, is it's, one, extremely complicated. It puts a lot of compliance burden on banks. And the bankers--I don't know many bankers: I know a handful who I interact with very casually in social settings now and then. And they all tell me that their world has gotten more onerous. There are more people around keeping an eye on them. Which is, could be a good thing. But they are obviously not going to like that. It's not surprising. So, Dodd-Frank raised the regulatory burden on banks. Everybody who has read it tells me it didn't solve the too-big-to-fail problem. And I know that's true, because we'd solved too-big-to-fail before, and we'd didn't usethose methods when the crisis came because it was politically unpalatable to do that. And it still is. So, here's what I see. And tell me if you think this is too pessimistic. This is probably, again, where we might agree. We've made the regulatory framework more byzantine, more labyrinthine, with the result that only the biggest banks find it easy to comply, because they can spread those compliance costs: they give a whole part of their bank devoted to Dodd-Frank. Smaller banks can't do that. So, what we've done is we've made the banking industry more concentrated, which means that their claims for work, the ease with they'll demand a bailout goes up--because they are more systemically--each one of them is more systemically important.
Rana Foroohar: Yeah.
Russ Roberts: They are more concentrated. And I just see this as the next forest fire is going to be even bigger than the last one. And the consequences will be worse. And my goal, which is--this is the naive, Quixotic part--my goal is to make it politically difficult for politicians to make those kind of bailouts. I want there to be, I want people to see behind what really happened--
Rana Foroohar: Mmm--
Russ Roberts: and make it culturally difficult--
Rana Foroohar: Mmmhmmm--
Russ Roberts: to do these things that I think are part of the problem. I don't know another way. I don't think we're getting there.
Rana Foroohar: I don't think we're getting there. I mean, I think that these are great points, and I would agree with about--well, I'd agree largely with everything you said. I do think the biggest--well, it's factual that the biggest institutions have gotten bigger. Which, by proxy I agree means that it will be easier for them to demand a bailout if there is a crisis. It will be harder for, or as hard as it was, for politicians to stand up to that. There's nothing in the legislation that explicitly prevents bailouts. It comes down to political will. I didn't see anything in Dodd-Frank that made me think that it was--that we had solved the too-big-to-fail problem. Dodd-Frank was incredibly complicated, though. Right? I mean it was spliced and diced not only by political factions but by the bank lobby itself.
Russ Roberts: Yeah. Of course. Always.
Rana Foroohar: And, you know, one of the--the "Author's Note" to my book, which I'll just mention because it was kind of a, the come-to-Jesus moment : when I realized I had to write this book I was sitting at an off-the-record meeting with a former Obama Administration official that was sort of trying to tie a bow around the Administration's handling of the financial crisis and kind of be like, 'Okay, we're all done; nothing to see here; move along, folks.' And Dodd-Frank at that time--it was 2013--and it was only maybe 50, 60% written. And I was looking into why that was, and I had found some academic research--
Russ Roberts: Shocking.
Rana Foroohar: Shocking. Yeah. Well, I mean it also goes to the point of the complexity--like, 'Hello?' But I'd found--there was this academic from the U. of Michigan doing God's work who tallied up all the public consultation meetings that had been taken on the Volcker Rule--which was the rule that was going to separate commercial lending from trading and was one of the most contentious parts of the legislation. They found that 93% of those meetings had been taken with the largest banks--many of them with, just a couple of institutions like J.P.; some of them with Jaime Dimon himself. It was just this very, very concentrated group of voices in the room at the time. And this official was arguing that, 'Well, we've gotten done everything that we needed to get done; and lobbying pressure was not a factor here.' And I raised my hand and said, 'Well, how can you say that when 93% of the voices in the room were the people that are being regulated?' And he looked at me with true bafflement and said, 'Well, who else should we have been talking to?' And that was the moment where I looked around; it was really interesting, too. This is an important point: This was a group mainly of financial beat reporters. There were only a couple of generalists like myself there. And I thought, 'Oh, my God, everybody's going to be scribbling. This is going to be the hot thing that happened in this interview.' Everybody was just kind of going along. Because the cognitive capture--
Russ Roberts: I was going to say, even journalists can have cognitive capture--can be [?] from it.
Rana Foroohar: The worst, you know. We can have a whole other podcast on what journalism does wrong. But I was just like, 'Wow.' I'm not saying when you build a bridge that you don't need a lot of civil engineers around. But you need some people who are going to be on the bridge, too.
Russ Roberts: It's an incredible problem. Partly because, as you point out, the people inside the bubble have been inside the bubble so long, and more importantly to me, profit from the internal echo chamber, that it doesn't even cross their mind. It's not like--again, it's not something sinister. They are not sitting around thinking, 'How can we--?' My version of this is Hank Paulson--I think--I'm going to forget these numbers, but Paulson talked to Lloyd Blankfein at Goldman Sachs I think 24 times in a 2-week period in the middle of the Crisis. And, my joke was, 'Well, they weren't talking about their kids' summer vacations.' And obviously, if I were the Secretary of the Treasury, you'd want to talk to some people at Goldman Sachs about what they thought was going on. They probably do have a lot of insight, useful information, that one would take into account. And I don't want to minimize the challenge, by the way, of being in that position. I'm very aware that it's easy for me to take potshots; that people are under tremendous pressure. But, couldn't they have done 99 cents on the dollar on some of those? I just--the fact that no one took a haircut other than I think one--I want to say, was it Washington Mutual? I can't remember. Everyone else just got all of their money back. And everybody got to stay in their jobs, too. They could have removed people and said, 'Okay, we're going to bail out all of your creditors, and they are all going to get 100 cents back on the dollar; but you can't do what you're doing any more.' And I just want to raise this, because I think it's really important. You were very critical of Chicago School economics for a couple of paragraphs in your book. And where I agree with you on that--and I wouldn't say it's literally Chicago School economists--but so-called free market types would say, 'Well, that would be wrong, to remove people, because that's not capitalism. The government shouldn't be able to remove people from their job.' And I agree with that. But once you say the government can then force people to be compensated for risks they took and messed up and get their money back anyway, you're in a different world. You can't [?]--that's the worst of both worlds.
Rana Foroohar: Yeah. No. I think that that's a hugely important point, and it's something that's not well understood, is that: Free markets have to be free markets. But what we have now is not something that Adam Smith would have recognized as a free market. I mean, Adam Smith would say you need 3 or 4 things for a market to be well-functioning. You need price transparency. You need equal terms for folks on both sides of a trade. He would have argued even that you need a kind of shared moral and societal framework--which is very, very interesting--for markets to function properly, because that's not what we have in this country. And I think that the point that you mentioned--the sense that the entire public had that, 'Hey, something's rigged here.' Well, we wonder why we had the election cycle that we did. And we wonder why Donald Trump is President; and we wonder why populism is raging in any number of countries. This is it, folks.
Russ Roberts: And why a 70-year[?]--an aging socialist almost defeated a--a real socialist, not just a left-of-center person, but a socialist almost got the Democratic Party nomination. It's because people have a sense that something's rotten. And they're right. Something is rotten.
Rana Foroohar: And they're right. That's right. And I think that--it's interesting to me because when I look at the 2016 election, I think that that's what people were responding to. And I worried--so much about Hillary Clinton's campaign because of that. People were responding emotionally. They were not responding to the particulars of any facts. I mean, you know, just listening to Bernie Sanders talk about the financial markets I would be like, 'Uch,' roll my eyes. But he and Trump both were capturing this soul-felt experience--
Russ Roberts: They were on to something--
Rana Foroohar: that people out there know. You don't have to know anything about Tier 1 capital t o know that something's rotten, as you say.
Russ Roberts: And as you point out, the fact that homeowners didn't get a bailout, is not a coincidence. It's not like no one thought of it. They just-for a whole bunch of reasons it wasn't as politically attractive as bailing out the funders.
Rana Foroohar: I think it's going to be really--just to talk about the current political milieu for a moment--I think it's going to be really interesting to see how all this plays out for the Trump Administration, because, you know, one of the things that happened with Obama, I think, one of the reasons that so much of what he wanted to do was derailed was because he didn't do the right thing, you know, on the financial crisis at the very beginning. Now, we've talked for an hour about why this is complicated and hard. But the bottom line is: The homeowners didn't get a bailout. Wall Street did. People knew something was rotten. And then not only did any kind of coalition on the Left break apart, but you sort of lost the good will of Middle America in a lot of ways. Now, I think it's going to be really interesting to see what happens on this score with the Trump Administration. I mean, it's somewhat different dynamics politically. But: Is Wall Street going to get a break? And are people--we may be coming to another financial crisis or a downturn sooner than we think. Trump is definitely unleashing animal spirits in some ways; but he's going to be fighting policy--against the Fed. And there's all kinds of international dynamics that may play into this. We're really at the end of a recovery cycle--we're 8 years now. Sorry, almost 8 years. And that's when recoveries end.
Russ Roberts: They usually end a lot sooner. This has been a very unexciting but long recovery that may--we're in uncharted territory. My view is--my listeners want to hear about trade issues at some point; I keep promising we'll get to it. But Trump has--
Rana Foroohar: Another exciting topic--
Russ Roberts: but Trump has unleashed some positive animal spirits; and some really negative ones for me on trade. I have no idea where we're going to end up. And he's got a lot of--well, we'll see.
Russ Roberts: Let's talk--we've got a few minutes left. Let's talk about what you might see--let's get out of the weeds. Because Dodd-Frank--part of the problem with Dodd-Frank, for me, is what you pointed out: That even in 2013 it was, what did you say, 50-60% completed? That to me is death to a democracy: To say that we're going to pass this big law to fix this big problem, but we're not sure what's in it; we're going write what's in it as we go forward in ways you'll never notice because you won't be paying attention any more. That's, to me, just not a good thing. And it's part of the administrative state that I think is another part of our problem. And I would add, just to come back to what we talked about before: For me, a lot of the uncertainty about regulatory detail and specifics is part of the reason that investment in America in real things is not so healthy. But that's--we could debate that; it's not an open/shut issue, obviously. It's a speculation. But, stepping back from the details: What would you like to see as--the short-termism that you decry: How do you fix that? You have to understand why it's there. I don't understand why it's there. Again, I am somewhat skeptical. And you think it's obvious. But if you want to change that, if you want to give more of a: Are you thinking about cultural change? At one point you talk about MBA (Masters of Business Administration) education being part of our problem; that's very hard to change; that ain't going to change tomorrow. What do you see as ways to maybe make things a little bit better.
Rana Foroohar: So, sadly, on the short term as a problem , I don't think that there's one silver bullet. I think that there's a few things--we talked a little bit about buybacks and the legislation around those. I mean, I know Liberals and Conservatives that would like to see us take a look at that 1982 and 1990s regulation and say, 'Is that serving people? Is that serving the markets? Is that serving the overall American economy, to allow the financial markets to operate in this way?' So, that would be one thing. Culturally, definitely business education I think has become focused a lot on balance sheet manipulation; and that's something that a lot of CEOs that I talk to have a problem with. Because it means that they can't find folks that are actually thinking about business and growth in a more wholistic way. They are tending to come out and just look at P&Ls (Profit and Loss statements), and: How do you cut costs? How do you marshal your capital? Well, we're actually living in a world with plenty of capital. Central banks have dumped $30 trillion dollars of money into the markets globally in the last few years. So there's plenty of capital. Talent, and workers, and consumers I think are where the action is. And I do feel that--we haven't even talked about technology, but it has a huge, intersecting effect here. Not only did technology speed up all the processes of financialization that we've been talking about, but giant tech companies in general are in some ways the new Too-Big-to-Fail, systemically important institutions. They are underwriting bond offerings the way Goldman Sachs would. But, guess what? They are not regulated like Goldman Sachs. And they are developing all these technologies that are changing the labor markets quickly and in profound ways that may affect underlying GDP growth and consumer demand. All this is to say: You need business executives that understand all of that and can think wholistically rather than just saying, 'Cut costs; marshal capital.' And then there's also this broader question that we touched on about what are the financial markets for. I mean, I would go back to Adam Smith and say the financial markets are there to support the real economy. And, how do we simplify regulation? This is total wishful thinking, but if the Trump Administration and the Republicans do throw out Dodd-Frank, there would be a golden opportunity--and I'm not particularly hopeful because of all the lobbying pressures we spoke about that it would be taken--but there would be a golden opportunity to rethink regulation from the ground up and say, 'What kind of a financial system do we want to have? Let's look at what banks and financial institutions are doing that we know is good for the real economy, and let's incentivize that, and really try and flip the paradigm on its head.' Start with what banks should be doing rather than trying to come up with 2000 pages of what they shouldn't be, and all kinds of loopholes that are going to enrich any number of white-shoe law firms.
Russ Roberts: Yeah--I want to see firms take risks, and be rewarded when they succeed and punished when they fail. That part seems kind of simple. I don't know why. I guess--I do not why. That's not enough. But I look at, say, you mention Silicon Valley, a lot of Silicon Valley companies which have very high market valuation may have a bankrupt business model despite their valuation. And Uber is an interesting example--some people say they are really not going to make it; it's just pipe dreaming; they are really betting on the driverless car possibility; that's going to be a very crowded segment; it may not succeed. And let's say they disappear. That would be--good and bad. Good for some people; bad for others. And there'd be some remaining competitors. Maybe. Maybe the whole business model dies out. And that would be the end of it. It wouldn't destroy the American economy. If the venture capital firms of Silicon Valley, which are very special in that they create this stew of new opportunity that's very unusual compared to the rest of the world--if they were to disappear or make a series of very bad investments, one of them, and they went to Washington and said, 'Oooh, we did really badly. We want our money back,' we'd all say--we'd laugh at them.
Rana Foroohar: I like your baby voice, Russ.
Russ Roberts: That should be the mode. And I don't know why we can't think that Wall Street should be more like venture capital firms. I want to let them rise and fall on their own successes and failures, and not on mine. I want my wallet out of the equation. And I just want to add--because I didn't get to pile on. I want to pile on. My colleagues in economics--I think, too many of them are the handmaidens of Wall Street, or the handmen--I don't know what the right phrase is.
Rana Foroohar: --there's a few handmaidens; not too many--
Russ Roberts: but have been the facilitators of this evil, symbiotic relationship between Washington and financial sector. And we should be more skeptical about its overall value. And of course, we are, as Luigi Zingales--you mention him a few times in your book; we've interviewed him here. He points out that we're kind of, we've got our own special interests. We're compromised as objective observers, many of us are. I'm not, fortunately; or unfortunately, depending on who you talk to. But I just think we need to be more blunt, and try to get out of that cognitive capture experience, and try to concede that the world is not working the way we sometimes claim it is.
Rana Foroohar: Yeah. Absolutely. Skepticism about the models is always a healthy thing, I think.