Steven Kaplan on the Inequality and the Top 1%
Nov 7 2011

Steven Kaplan of the University of Chicago talks with EconTalk host Russ Roberts about the richest Americans and income inequality. Drawing on work with Joshua Rauh, Kaplan talks about the composition of the richest 1% and 1/10 of 1%--what proportions come from the financial sector, CEOs from non-financial corporations, athletes, lawyers and so on. Then he discusses how the incomes of these different groups have changed over time. Kaplan argues that these groups have increased their incomes by similar proportions, suggesting that a failure of corporate governance is not the explanation of rising CEO pay. The discussion closes with a discussion of the financial crisis and the compensation in the financial sector.

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


Nov 7 2011 at 12:30pm

“As an economist I find it deeply annoying, and especially when economists do it–income is not a 0-sum game. Somebody else’s income does not come at your expense. It could; and we’ll talk later about when it does. But in general these numbers don’t have automatic implications for the 99%.”

I think income is the wrong question. I think production might be the right one. Production is rather ‘inelastic’. And unless you are a keynesian, or believe there are serious money supply issues, income has the effect of shifting bargaining power in the market place.

“He writes that book in 2005, 2006; and he’s the Chief Risk Officer. He wasn’t fooled. But for some reason when he tapped his boss on the shoulder, presumably his boss said: Leave me alone. Maybe it was a human failing.”

The problem comes when assets need to be managed. We need pension fund managers, because we need pensions. 401k managers, because we need 401ks. This is regardless of whether or not there are enough investments that have a high enough return to support all of these pension and 401k funds.

Return is often obtained where the rest of the market gets the calculation wrong in a exploitable way. If everyone knew the future risk of everything perfectly, the return on everything would be equal. In fact the smarter we get as a whole, the lower the returns become, because of the decrease in exploitable risk.

If someone wanted to fight fund managers, they could do so by providing the public with lower risk models than those produced by the industry. Just like travel agents, if fund managers can’t do better than than the public their value decreases. And, unlike travel, lower risk models can have the effect of drying up the exploitable risk market altogether.

This ‘world of perfect information’ would present a tremendous problem for pension and 401k managers that need funds to grow fast enough to sustain a person/family through their last stages of life. Auto Insurance, Home Insurance, Medical Insurance, Mortgage Insurance, Life Insurance, etc, etc, are all competing efforts in these risk markets.

It’s not all ‘Gordon Gekkos’ on wall street…There are good people making predictions, for very good reasons.

In a world of perfect information, all insurance just becomes risk pools. But even then, how in the world would anyone accurately predict how much money I need for retirement in 30 years? We can’t even guess events 2-3 years in the future…..if you know the price of heating oil next year, you can make a killing in the market, and decrease the risk for the rest of us….

Yes, making predictions is a hard job. And, yes, most guesses about the global economic future will always be wrong in some degree. But even worse than making ‘so-so guesses’ is just leaving everything to chance. Even a few percentage points matter when we are talking the retirement funds of a whole generation over 30 years….


Nov 7 2011 at 1:32pm

Here is a link to a project The Economist created on its website to debate the question of executive pay. Steven Kaplan argues they paid just right & Nell Minow takes the opposing view and then readers vote. Be sure to click through all the tabs as opening statements are one day/tab, rebuttals another day and closing arguments on the last day.

Corey S.
Nov 7 2011 at 8:56pm

I’m not sure your guest was correct on his point about taxes. If the CEO’s made section 83(b) elections and held the stock for longer than a year, I think the gains are taxed at a lower rate than the normal income tax rate.

I don’t have time to look up exactly what it would be, perhaps a tax lawyer could comment on it.

Nov 8 2011 at 3:06am

Health insurance costs raise the proportion of high earner income, by moving a fixed amount of low paid employees’ real pay out of their adjusted gross income.

Since it works by reducing the denominator, it’s probably a big effect.

W.E. Heasley
Nov 8 2011 at 6:47am

Excellent episode.

One needs to pause for a moment and ask an important question: what is the exact empirical formula for the perfect distribution of income?

Have you seen the formula? Problem is that no such formula exists. Hence, is the current distribution the perfect formula? Was the distribution of income prior to 1880, 1905, or 1930 the correct distribution of income? Is mal-distribution of income the perfect formula?

When no such formula exists a very common occurrence is the phenomena of “the middle”. That is, if one has no evidence that a perfect formula exists then one opts for the middle of two extremes. Stated alternatively, “equality of income” is really an argument of “middle of income” as no empirical formula is present and hence the middle becomes the default answer. That is, “equality of income” is not empirically based, its notional based and notionally presented.

“It is no less arbitrary and dogmatic to declare a priori that “the truth lies somewhere in between.” It may. It may not. On some highly specific issue, it may lie entirely on one side – and on another issue, with the other side. On still other issues, it may in fact lie in between.” Thomas Sowell, page 215, A Conflict of Visions.

Nov 8 2011 at 11:19am

One needs to pause for a moment and ask an important question: what is the exact empirical formula for the perfect distribution of income?

I think this is the wrong question…..I would like to suggest that there are philosophical questions that must be answered before we could ever get to the empirical ones….

The main question would be ‘what is right?’. To answer this, I think we have to go to something like the ‘Theory of Moral Sentiments’, which at its core, argues that we know what is right by how the results of an action makes us feel…it’s the Sentiments generated by the results of an action that decides the Morality of an action….

This leads to what I call ‘Sentimental Consequentialism’. In that its the ‘Sentiments’ that result from an action that decides its ‘Morality’. The core objections to ‘traditional Consequentialism’ are typically that its adoption leads to negative consequences, (a Consequentialist argument in itself).

What makes ‘Sentimental Consequentialism’ difficult, is that people are often very poor at making accurate predictions of the future, even more so about their reaction to the results of an action. But, this fact would equally weaken any alternative predictions of the future. And, then you are left with making the best guess based on the tools to best make guesses.

This can become a very long discussion, but again, I think any focus on the empirical questions (including questions of “equality of income”, or “perfect distribution of income”.), before we have worked through the philosophical questions is premature.

And, yes, I would like to suggest that morality can not be found in empirical accuracy. Empiricism will lend credence to any prediction of the future, but I’d like to suggest that the morality of that result lies in our ‘Sentimental reaction’ to the numbers, and not in the numbers themselves.

And, yes, if morality is to be found in ‘Sentiments’, then it is very possibly the case that these will be notional based and notionally presented. I guess Neuroscience could show empirically how strong a ‘Sentiment’ was, but, yes, at some point all arguments have to be based on axioms which are stated a priori…


Tim Bugge
Nov 8 2011 at 11:38am

A concern for “fairness” is what drives interest in this topic. Wealth and income are used as proxies for the presumed “standard of living” they provide. The real question implied is… what is happening to the size of the gap between the the various percentiles mentioned when we look directly at the experience of the “standard of living”. How much “better” is the existence of the 1%er’s than the rest of us?

Nov 8 2011 at 12:45pm

Off topic. But, can you get Dean Baker sometime on the show? I’d like a back and forth with someone well on the left but whose economic/political model is clear to comprehend and debate.

Nov 8 2011 at 12:53pm

I wanted to address a few points raised in the podcast.

In one section, Russ Roberts claims that that the top 1% are not the same 1% as 30 years ago. That’s true, although it’s also worth pointing out that the US has low social mobility (we like to believe that anyone, anywhere can make it but statistically speaking it happens less in the US than it does in other developed countries and it happens less in the US than it used to historically). See Figure 2:

The claim was made that the top 1% get hurt more by recessions. Well of course they do. The top 1% own nearly 40% of the stock in the US. The next 19% own another 53% of the stocks. Their fortunes rise and fall with the stock market. I don’t take it as any kind of comfort that the rich get harmed more by recessions when the cause is that their extensive stock ownership didn’t do as well. See table 5a:

Let’s also point out that conservatives like Cain and Perry want to eliminate the capital gains taxes, which will cause billionaires to pay next to nothing in taxes since they won’t have to pay any taxes on stock earnings, which is where they make most of their money. (As Warren Buffet’s article recently pointed out: some of his Billionaire friends make *all* of their money on stocks.) That’s a shocking admission that Republicans are engaged in class warfare and they’re fighting on the side of the very rich.

At 25 minutes into the show, the claim was made that pay rates for CEOs were similar all over the world, suggesting that nothing unusual was happening in the US. On that issue, take a look at figure 8 and figure 9 showing skyrocketing CEO pay historically in the US.

More importantly, the data shows that US CEO pay is far ahead of CEO pay in other countries: “Study shows U.S. bank CEO pay dwarfs rest of world”

Alternatively, this article says US CEO pay isn’t that unusual (but it was much larger back in 2003), although they note at the end that this seems to be partially due to US-style compensation being exported to the rest of the world.

It’s also worth pointing out that there’s been a massive amount of bank consolidation in the US – which is both unstable (the few mega-banks left are far larger than they were 10 years ago, and “too big to fail”) and their size somehow legitimizes huge pay (if pay is related to the size of the company). I’d much rather have 100 CEOs earning $1 million/year than one mega-corp with one CEO earning $100 million/year.

Greg Webbink
Nov 8 2011 at 1:22pm

It would have been interesting to have Steve Kaplan’s comments on growing income disparity rather than argue that public company CEO’s have not experienced any greater increase in compensation than the rest of the top .1%. There is a distinction to be made between the super-rich whose compensation is made by themselves (e.g., the Jobs, the Gates, and other innovators and developers) and those whose compensation is only possible through the capital (hedge funds, private equity, etc) or labor (public company CEO’s) of others. The fact that CEO’s compensation as a multiple of the average worker compensation grew from a factor of 42-to-1 in 1980 to over 400-to-1 in 2006( is increasingly tearing our society apart.

Further, Steve’s comment about the tax treatment of restricted stock and options, as if it’s fact, needs further investigation. My understanding is that the grantee can elect when to recognize the income effect for tax, although the basis will be based on when it was granted. It would make NO sense for an exec to recognize restricted stock for tax purposes if it’s under water.

Finally, Steve completely discredited himself in my mind when he disclosed his participation on various corporate boards. Playing off of Steve Jobs, Steve Kaplan’s views seem to reflect his own “reality distortion field”.

Nov 9 2011 at 1:14am

“Recessions are bad for the rich. If you care about inequality per se, recessions are great.” -Russ

This is a great line from the podcast.

Image of cutting off one’s nose to spite his face came to mind.

Nov 9 2011 at 1:32pm

I’m sorry but I am so bored with people building a narrative around their philosophical house.
It’s clear that our economy has been financialized with the take of corporate profits from finance going from some 15% to 35% over the last 30 years. This financialization has played a huge part in the rising income at the top 0.1%. It’s policy driven and it’s not benign to the larger economy.
I love it when Mr Kaplan makes the point on bailouts, “Because these sorts of events have happened really through all time. You had the Panic of 1873, very similar, people losing their own money; 1907, people losing their own money; you had 1928, 1929 people losing their own money; and then you had 2007-2008, which looks a whole lot like those other episodes.” Without acknowledging the huge gap of time where there were no episodes to point to.

Andrew Ashurst
Nov 9 2011 at 8:34pm

Presumably Kaplan’s numbers are based on declared income at IRS. Investigations such as Nick Shaxson’s (Treasure Islands) add a little more flesh to what we all know already. The rich pay relatively low rates of tax as they are able to disguise much of their income inside complex legal structures as not being theirs. Failing that they just hide it, or hide it anyway, Delaware etc. Moreover, as alluded to in another comment above, income is not the same as wealth which is easily hidden or at least kept out of the reach of the tax man. It is a large part of the financial and legal infrastructures job to do the hiding. They get well paid for that of course.

I just don’t believe in this talent argument. I’m not saying that they are dumb. I guess they are of varying intelligence like the rest of us. Much of this talent is just ordinariness in good circumstances (see Gladwell – Outliers, based on Univ of Florida research I think). No, the obscene pay in the financial industry is clearly related to that industries privelege in creating the money supply and ongoing closeness to the longstanding wealth of the plutocrats whose bottom assets are still land. Hedge funds, private equity, ok there will be some capital there I suppose but much of it is credit created by the private banking system. Given that the financial and banking system gets to create money it’s hardly surprising that they get to keep a good chunk of it.

As Keiser keeps saying (I’m aware he’s on RT – but someone has to be the antidote to Fox News) no-one is being brought to book for making the mess. The money made on the way up by this industry and it’s insiders was made just betting with the market with leveraged funding, not being smart just greedy sheep. A lot made enough money in the good years that it hardly matters to them (all but the most profligate and truly stupid) that they are having to get by on their salary and 2/20 as you say, or just live off the interest now for a few years. Business, more or less, as usual will resume eventually.

Ticket to ride. It’s just a case of getting the foot in the door. The right connections, right schools same as it always was. I know of a Swiss business man who wrote, secretly of course and for payment, a PHD thesis for a scion of a banking family. The scion could talk the talk well enough and so didn’t really need a PHD other than as a badge that then allowed him to participate, to be at the table, and so legitimate the high income he would then become entitled to. The transaction seemed perfectly ordinary – of course the cost was out of reach for most of us. So that’s what private tutors do then. I digress.

Then you say that Lehman’s and Bear Stearn’s excuse is that they were stupid? This after you’ve just told us how talented these people are and that’s why they earn so much. I’m UK based so I’m not aware of the fate of the senior execs at those banks, but, my guess is, high paper losses or not, they still have lifestyles that would qualify them as wealthy, they have connections, I guess they will continue to live well (I wrote that prior to learning that they may still have 1/2Bn$ fortunes). Even if Kaplan is right, so they are left with, let’s say, only $5m, that is still very wealthy by normal standards. Don’t you see that? How do they deserve even that? A reasonable investor, and aren’t these guys supposed to be clever, and well connected, running a portfolio that size should still make a top 1% income. Do they deserve that?

Your message seems to be that it is this way because it has to be and there’s nothing that can be done about it. Somehow the situation we have now is a result of some natural laws, but it isn’t.

Kaplan made one point about the leveraged buyouts of firms rather than the real estate blow up to somehow illustrate that the last bubble wasn’t all bad and “heads we win – tails you lose”. M&A is not generally about economic efficiency or the the future of America and certainly isn’t about jobs for the 99%. The new entities don’t even have to be successful, reasearch show they generally aren’t. No the deals are about the fees generated for the financial sector and the large salary packages for the executives. Somehow we are to be grateful that they mostly haven’t gone bust. Is that the measure of success now – just managing to pay off the debt (bankers fee’s rolled into it of course) and interest while carrying the overpaid execs and not going bust.

It doesn’t have to be this way. Two complementary and alternative approaches to the economy exist, still compatible with a capitalist system but which make it harder for a small section of the population to live off the work of the many, or on the other hand for the financial sector, the banks, to live off subsidy from the taxpayer, that is from, in US English, mainstreet. Of course both will require substantial realignments in society and losers will complain loud (like trade protection losers). The losers will be the plutocrats of the top tenth of the 1% and their bureacracy, the financial sector which is much of the rest of the 1%. Its hard to get these alternatives even talked about.

They are, tax reform, being Land Value Taxation (yes, Henry George and all that) and monetary reform in the form of Full Reserve Banking. For monetary reform I like a UK website, I believe there are US equivalents of it arguing for much the same program. I think, from the last few minutes of the podcast, this sort of reform may be close to something you are advocating. I don’t think LVT is on your agenda, though I’d like to be wrong. I like LVT and monetary reform. Both for me please.

History is not over. The English did behead their King a few hundred years ago. The French took out their aristocracy a little later. You had a bloody civil war not that long ago. Things are getting quite lively around the world today. Gaddafi murdered, Hussein, Bin-Laden dead, Mubarek deposed. Maybe this crisis is not going to be bad enough to bring forth serious unrest in the West, only acquiescent misery, maybe the odd looting. But, at some point, unless change is achieved democratically – which I doubt, one will be bad enough and then, inter-alia, economists like the two of you will have to stop being so polite to each other so that the rest of us can tell more clearly whose side you are on and what you want. It would be better if you stopped being so polite now so that the arguments can get a proper public hearing – perhaps then change may be democratically achieved. Personally I think it will take something very dramatic to one day move these tectonic plates.

Nov 10 2011 at 3:12pm

It seems to me that Kaplan could have put his time and effort to better use by determining if CEO’s and other top executives get paid commensurate with their performance.

Are they getting bonuses and options during down years as well as up years? I’ve heard the argument that they deserve their bonuses during up years because they earned it. They deserve their bonuses during down years because they prevented things from getting worse then it could have been. They deserve their golden parachute as they exit a crumbling company because they are such great people and work so very hard.

Kaplan states he wanted to do this study because of the complaining about lack of board oversight, but what the heck does that have to do with the top 1%?

Why should wall street companies be removed from the data? Does he believe they are as a group over paid and under supervised by boards?

Finally, I have to agree with other comments pointing out that CEO and executive pay have increased greatly in the USA, especially when compared to stagnant wages of the average American worker. This causes me even more pause when considering whether to give Kaplan any credibility.

I think Mr. Kaplan should remember, the CEO and executives are there for the benefit of the shareholders, not for stuffing their own pockets.

Too many companies have failed to give even a modest return to shareholders, yet the bonuses, stock options and sky high salaries continue unabated. I know this by simply reading the many shiny full color annual reports I receive. If you are to believe the letters from management, many of them are supermen who prevented complete collapse of the business, and that is why they deserve the bonuses and stock options, but why so many shareholders only got part of their usual dividend checks, if any at all.

Nov 10 2011 at 4:34pm

The best part of this podcast was the debate about Russ’s Financial Crisis theory. I’m curious to see how he addresses the criticisms going forward.

I find it very strange that Kaplan’s argument revolves around the high pay of hedge fund, venture capital and private equity executives. First, it’s very hard to prove these people have any skill. (which he acknowledged to his credit) Then, he gives a story about compensation, arguing that undercutting on price would signal low quality and thus won’t happen. This story requires that a managers type is unobservable.

So the argument comes down to, CEOs aren’t paid too much, because these other managers pass the market test so they can’t be paid too much. Yet, he acknowledges that the market must not be able to determine how much these people are worth. If the market could determine that, managers could compete on price. So it’s hardly obvious that passing the market test is telling us anything at all.

Nov 11 2011 at 3:50pm

Wow what an informative exchange at the end of that podcast. I had not heard Kaplan’s point on leveraged loans v. mortgage loan before.

Sometimes I feel like I’ve heard everything about the crisis but that’s such a novel (and compelling argument). If its heads I win/tails you lose, why no market failure elsewhere.

My guess is that govt. interference is still at play. There’s no Fannie/Freddie in the PE world (I think). Would love to hear more on that.

John Berg
Nov 12 2011 at 8:10am

As Thomas Sowell mentions in his 8Nov2011 article, “Numbers Game,” the real issue rests on whether a man’s income, with proper planning, rises over time. A similar issue may be: will a family’s income increase, with proper planning, generationally.
Has this been demonstrated? Has it been demonstrated that certain aspects of the tax code limits anyone at certain points in their maturation?

John Berg

Alan McCrindle
Nov 13 2011 at 3:33am

Hi Russ,

let me give you points for trying to plug the hole that existed in the income inequality podcast with Bruce Meyer that had excluded the top one percent.

Moreover let me give you credit for asking many questions that needed to be asked that weren’t in that podcast.

Globalisation has played a role in the inequality story. The top end of town has had access to global markets and the increased profits that come with that. What was omitted in the explanation was that globalisation has also globalised wages of workers and that has hurt the people at the bottom in developed countries.

Having said this, there were two fundamental gaps in the analysis that I noticed.

The first of these was the use of “pretax income” as opposed to “post tax income” as the measure for income. The second was the base used for comparison of wage increases. Let me elaborate

On the first, pretax income is a poor measure for capturing income inequality and differentials for two reasons

– first we are looking at a period where tax rates on income have declined massively and the biggest beneficiaries have been the high income earners (marginal tax rates have declined from a peak of 95 cents in the dollar for high income earners)

– second, tax on “capital gains” has dropped to the extent that Warren Buffet pays less tax than his secretary. The main beneficiaries here have been Private Equity and Hedge Funds. And a big question here is exactly what has private equity added to the equation other than debt? Most of the “investments” subject to 15% capital gains tax did not create new business and jobs – they destroyed jobs and left US manufacturing a wasteland. Private Equity profits were primarily the result of a combination of falling interest rates and rising equity prices. Neither of these were the result of any superior skill set.

Here is an interesting fact – provided courtesy of Robert Litan, who directs research at the Kauffman Foundation, which specialises in promoting innovation in America: “Between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less,” said Litan. “That is about 40 million jobs. That means the established firms created no new net jobs during that period.”.

And on the question of Private Equity defaults being lower than expected – I think the jury is still out on this one. The US economy is not coming back anytime soon. It is only going to get worse and interest rates may just go up – they can’t go much lower. Moreover the issue will raise its head when these companies have to refinance – see WSJ Feb 20 2010 – Moody’s warns of deluge of dent – “Moody’s Investors Service warned of sizable refunding requirements for nearly 1,000 companies over the coming years, questioning whether they will be able to refinance more than $800 billion in debt taken on in the middle part of the last decade.The credit-rating firm’s annual report on risks faced by weaker companies and their investors found that 995 of the 1,300 companies Moody’s rates as “junk” have debts maturing in the next five years. The debts are largely tied to the last decade’s leveraged-buyout boom.”

Second, the argument that CEO’s pay rose at a similar rate to others in the top 1% – and therefore was a non issue in income inequality – simply misses the glaringly obvious fact that the ratio of CEO pay to worker pay has increased dramatically. Cognitive dissonance.

Another black hole in the argument relates to the notion that you have to be really skilled to get people to lend you money for PE or Hedge Funds. Sorry it is a closed shop at the top. Private Equity is such a misnomer – a more accurate word to describe this business is Public Debt. Why? Because most of the funding comes from pension funds ( ThePublic) and Debt. Don’t worry – you aren’t the only one to be fooled – we also have a Health Industry that has nothing to do with health and everything to do with sickness and making money out of suppressing symptoms rather than raising health.

So how do pension funds work? They compete with each other based on their short term performance. Managers are also rewarded for this short term performance. And when their investments collapse there is no claw back of performance bonuses. Further more the managers have the excuse that they can’t be blamed for failures because all their competitors made the same mistake.

So pension funds are playing with other peoples money just like the Investment Banks were and are. And right now pension funds have a huge investments in stocks, Why, I can think of two reasons off the top of my head. First stocks are returning more than alternative investments like properly of debt . Second, all their competitors are investing in stocks.

However high stock prices have got nothing to do with how well the economy is performing – they are a function a low interest rates – the jobless recovery. And this has nothing to do with executive prowess or investment nous. It is the Fed pushing on a string and this effort will fail eventually.However everyone will be able to say they never saw it coming – everyone else made the same mistake so we can’t ne wrong.

You were right about the heads I win tails you loose hypothesis. You only have to work in the “real world” to understand how incentives work. However few in the “real world” want to mention this because it doesn’t fit their internal story of being moral and smarter than everyone else. Do yourself a favour and read “Mistakes were made (but not by me)”. It will lift the veil on how the people you interview selectively ignore anything that doesn’t fit their story while emphasising “facts” that do.

And three possible simple solutions to resolving the inequality problem –

1. Give money an expiry date with the option to keep it alive by paying a small fee (this is how one Austrian town escaped the depression)
2. Raise marginal tax rates – say 95% for any income over $1m (this is how we created the middle class)
3. Raise death taxes – say 95%

Nov 15 2011 at 6:30am


I just wanted to sum up my thought regarding several recent (ish) podcasts looking at inequality etc. Apologies if this repeats other comments, I haven’t read them all.

1) I think there are two things to consider in this debate. The first is the “level” of income / consumption of society as a whole. Within society, there is a structure (%iles and so on). So the second thing to look at is the distribution of relative income / consumption within society. Beck has written about a phenomenon in the German context that he calls the elevator effect (Fahrstuhleffekt), where over time, society as a whole has become richer etc., but the structure of society in terms of distribution has not changed. I wonder if for American society there may be the odd bit of evidence to suggest that while as a whole, society has become richer, the social structure has changed to make the bottom %iles relatively worse off.

2) In the podcasts, equality has been considered mostly in terms of income inequality or consumption inequality. While these are important, I think that money is really only one aspect of inequality. This was touched upon briefly when access to medical care was discussed. It would be interesting to look at the subject of inequality and it’s path over time from a sort of “commodities and capabilities” perspective. It would allow you to discuss issues like institutional bias / power structure, access and democratic participation. In my opinion, these are much more relevant indicators of “the good life” than money alone.

Best wishes,


Nov 17 2011 at 9:16am

I think this episode kind of missed the mark. You talked a lot about the details of the pay structures of senior executives and money managers, which was marginally of interest. However, the discussion only circled vaguely the core issues which are to my mind:
* the gap in wealth distribution (not income distribution)
* is this gap growing or not?
* is a large gap harmful to society and how?
* if there is a gap, how did it come about?

I know you had a recent episode with Bruce Meyer on inequality. He seemed to be suggesting that the middle and lower classes were not stagnating, but were seeing improvements in quality of life in real terms (though maybe not in nominal terms). This was also beside the point, since it is the (growing or not?) gap between lower and middle classes and the rich which is of concern. Anyone who reflects for a moment will realize that quality of life has been increasing in real terms for everyone. It is the relative gap between the wealthiest and everyone else which is socially disruptive. Our hunter-gatherer ancestors did not kill each other because they lacked penicillin or playstations. They killed each other for the best of what they did have: the best food, best mates, best place by the fire, etc. Absolute increases in real value are certainly important, but they are not the cause of social unrest, distribution of wealth is.

In this episode, you put forth some intriguing possibilities, but didn’t explore them much further. For example, you suggested that the top 1% today is not the same people as a generation ago. This seems to entail that there are new waves of billionaires who make their fortunes every generation, and that the size of their fortunes they make today is greater than in the past. Prof. Kaplan suggested this was due to the forces of globalization making it easier for someone to leverage their talents much more than in the past. This would go a long way to explaining the growing gap. I would really like to hear more about this – the demographic and cultural forces behind the wealth gap.

Pierre Boileau
Dec 3 2011 at 12:07pm

I have to agree with corvi42, I think this episode missed the mark.

Recent data from the CBO seem to indicate that income inequality (perhaps a proxy for wealth inequality – at least for the 99%) has increased over the last 30 years. According to the CBO, income for the poorest quartile has only increased 18% over that time period (essentially not keeping up with inflation), while for the middle class it has increased by 40% (just keeping afloat with respect to inflation). However the top 1% have had an income increase of more than 200% over that time period.

It would be nice to hear a discussion of the socioeconomic implications of this inequality, because I believe that is where the Occupy movement is coming from.

Just as an aside, I have to agree that, whether consciously or unconsiously, executives and fund managers in the financial sector believed that the ‘heads I win, tails you lose’ model was in effect once the deregulation efforts were successful. I congratulate the host.



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0:36Intro. [Recording date: November 1, 2011.] The super-rich, the top 1%, sometimes the top 1/10 of 1%; and we are going to organize our conversation around a paper you have written with Joshua Rauh, "Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?" There's a lot of evidence that the richest Americans are richer than the richest Americans of the past. I phrase it that way because it is important to remember that in most of the recent discussions of inequality--and it's a very hot topic right now--we are typically not talking about the same people. So, when people say the top 1% have gotten richer, that does not mean that someone who was in the top 1% in 1980 is now making a lot more or has a bigger share today than they had in 1980, because they are taking a snapshot, a slice in time, of a segment of the income distribution, 1980 versus today or today versus 1995. That's a really important distinction. I'm sure we'll blur it because of the nature of the English language, but I want everybody who is listening to remember that that's what the data are literally measuring when we are talking about the top 1%. There are data that look at the same people over time, and they often, by the way, get a very different pattern of who has gotten the gains and the relevant amount of inequality over time. But we're going to stick with the standard view, which is that if we look at a snapshot in time today versus a snapshot in time a while back, whether it's 15 or 20 or 30 years ago, the people who are in the top 1% or the top tenth of 1% have higher shares and typically make more money--and sometimes a lot more money--than the people who were in the top 1% in the past. So, how much has changed? How much richer are those folks at the top compared to those folks at the top a while back? The comparison I think most people focus on is if you go back to, say, 1980 or the late 1970s, the top 1% earned roughly 10% of the adjusted gross income in the United States. So the way this is usually framed is in terms of income shares and it's pre-tax income, it's adjusted gross income, so no taxes. But in the late 1970s, early 1980s, it was about a little under 10% of adjusted gross income and it peaked in 2007 at exactly 23.5%. So, if you look at pre-tax income of the top 1% it went from under 10% to 23.5%. Now, what's interesting about that is the 23.5% in 2007 was the second highest on record. The highest and highest still is 1928, where it was 23.9%. Ah, the good old days. Now, it's not comparable because taxes were a lot lower back in 1928 than they are today, so after tax you might get a different answer. But pre-tax it was very high. In the last two years, it's way down. Recessions are bad for the rich. If you care about inequality per se, recessions are great. That appears to be true, so in 2009 the top 1% I calculated at 17.6%. I've seen other calculations a tad under 17%, but it's basically gone from 23.5 to 17. What's interesting about 17 is that inequality in 2009 is actually lower than it was during any year of Bill Clinton's second term. Interesting. Now when we talk about the top 1% of adjusted gross income, what is roughly included in that measure of income? It includes, obviously, earnings that you earn in your paycheck; but it also includes capital gains, right? It includes earnings, capital gains; it wouldn't include interest income for example on municipals; it would include gains from options, gains from partnership. So, it includes quite a bit. I think the one thing it doesn't include that some people at least used to get a fair amount of income from is income on municipal bonds, although that's gone down quite a bit as interest rates have gone down. So, the trend over all overall, take out the recession. Actually, I want to first quote P.J. O'Rourke because I think this is important to keep in mind and often forgotten; he says: Wealth is not a pizza. So, if somebody gets a bigger share of the pizza it doesn't mean you have less to eat. For example, when that share fell from 23.5 to 17 over the 2007-2009 period, that wasn't good news for the rest of us in the 99% because our incomes also went down. Theirs just went down a lot more. Correct. As an economist I find it deeply annoying, and especially when economists do it--income is not a 0-sum game. Somebody else's income does not come at your expense. It could; and we'll talk later about when it does. But in general these numbers don't have automatic implications for the 99%. No. Clearly in 2009 a falling tide sank all boats. At least on the incomes share side it hurt the top worse than it actually hurt the bottom. When you said all boats, you actually meant most; there are a few industries that thrive during bad times. Economists being one of them. Most. I knew what you meant. Most boats; than you. I always like to note the poignance that most of us didn't predict the recession; those of us who did I think were mainly lucky; and who don't seem to have a clear picture of how to get out of it are the ones who are benefiting the most. There's a tragic irony there.
8:06So, what does it take to get into the top 1%, approximately? How much adjusted gross income do you have to have? And remember this is adjusted gross income--it's after some deductions. The standard deduction; what else is deducted from it? It's not your raw income. Taxable income takes out the standard deduction. Adjusted gross income is before any deductions. How much do you have to make to get into the top 1% today? It varies. I would say it's somewhere between $300,000-$400,000. It varies from year to year. In 2007, it was over $400,000; in 2009, probably the lower end of $300,000. And again, this is income, not wealth; so the assets that get you into the top 1% would be very different number. And that's much harder to calculate. Income we can measure pretty well thanks to the IRS; wealth is very hard to measure. It's based on surveys and you don't necessarily know whether you are getting a representative sample. I think Ed Wolfe at NYU is the big guy on wealth distributions; the data are hard. It looks like sort of for wealth the top 1% looks like somewhere between $5 and $10 million on assets. Going back to income, how much income do you have to earn per year to get into the top 1/10th of 1%? The top 1/1000th of the American income distribution. There we are looking at in 2009 it was on the lower side, roughly less than a million and a half, roughly $1.4 million. In 2007, our peak year, you had to earn over $2 million. Paul Krugman recently blogged--I forget where he got it from--made the observation, which I think is true, that much of the gain in the income share of the top 1% is actually accruing to the top 1/10th of 1%. I forget over what time period he was looking--at least the 1990s and the 2000s. This is not so clear. I like to stop at 2000 because this is was the last year of Bill Clinton's term. It was also the last year before the 2001 recession. A mini-peak. There the top 1% had 21.5% of income and the top .1% had about 11%. So, half of the top 1% went to a tenth of that group. Correct. And that seems to be--I'm looking at the pattern here--pretty consistent over time. Is that true in 2007? In 1980 the top 1% got 10%; the top .1% got 3.5%. In 1980 I guess it was 35%. Pretty big increase. More recently it's been close to 50%. So his point that it's gotten more skewed is correct. What about the 2007--have you got that? 2007 it was basically 23.5% and 12%. So, about the same as it was in 2000. In 2009 interestingly, 17.6% and 8%. So, 2009, the very top took the biggest hit in some ways. It's still about half. His data showed the share going to the top .1% starting around 1995, a year I think is somewhat significant and we'll come back to that later--could be a coincidence, a post hoc ergo propter hoc fallacy on my part.
13:00I want to talk about your work now with Joshua Rauh. In your study, you made a very heroic attempt to figure out almost literally how many and certainly rough percentages--where do those top 1% and top .1%, what are they doing, where do they come from, what are their occupations? We have an idea of what classes of occupations and industries these folks are found, and you tried to actually measure it. So, it's easy to throw around, and I do this myself: well, we know there are a bunch of groups that are really rich--entrepreneurs who run their own companies, CEOs, hedge fund managers, execs, athletes, celebrities. But what we really care about is how important are each of those groups? I feel very differently about a great athlete like Albert Pujols who is in the top 1% and is going to do even better than he has in the past probably, versus somebody who through corporate financial manipulation or government policy is able to exploit leverage and bailouts and get people to lend him money at cheap rates, etc. What do we know about the mix of people in that top 1% and top .1%? The motivation for that paper came to listening to pundits and even some academics say that income inequality was largely driven by CEOs and public company executives who were getting paid huge amounts. Ripping off shareholders, controlling their boards; there was no governance; and that the corporate governance system in the United States was broken. And the argument those people made again is everyone else is paid on an arm's-length basis; the CEOs are the only ones who--they control their boards, they set their own pay; and there is this view that they are out of control in driving everything. It just keeps going up and up because it can and all the social forces that used to restrain it aren't there any more--that's one argument you hear. Exactly. And I sit on a couple of boards; I teach people who are on boards; and I had a more positive view of boards. I think or at least thought at the time that many boards at least try to do the right thing; I had a view that there was a market for CEOs and that CEOs are paid a lot but it's a really tough job and they maybe should be paid a lot. So, what Josh and I did was we looked at all these other groups to compare how the CEOs did to those other groups. And thereby figure out how much they contribute to this issue. And so, the hard part about the paper is you have this great data on what top executives are paid because you have public disclosure. The SEC requires you to report that. You don't have such great data on everybody else; and so we cobbled together whatever data we could to do a comparison. So, we looked at investment bankers and at public filings of compensation from the top investment banks; we had to make some assumptions but we attempted to generate how many of them were highly paid. We looked at hedge funds; they grew enormously in terms of assets under management from 1990 to 2007 and even today, although it's come down some since then. We looked at private equity investors and venture capital investors; private equity also the assets under management have grown tremendously in the last 20-30 years. So we know the fees that are paid for hedge funds and private equity funds and we could make some assumptions about how many people were highly paid. There's actually reasonably good data on professional athletes. And there's some data you can get on lawyers--top partners at law firms--and we looked at those as well. And there are some obvious categories you don't have data on; so you don't have doctors, privately held firms, principals and executives, owners, etc.; some entrepreneurs are not going to be in the mix. Closely held businesses before they go public. And listeners can go look at the paper--some of the estimates you had to make somewhat heroic assumptions; others you had pretty good data and it spoke for itself more or less. Having done all that, what part of the universe do you think you captured? What's your estimate of what part of the top 1% you were able to observe? At the end of the day we think we captured, depending on what percentile you fall upon, but from the top .1% to the top .0001%--we got somewhere between 15-25%. So, let's say we got 20%, we think. Let's say it's 20%. That means that 80% of the people we've been talking about you didn't observe; they are from categories you don't have data about; but are you pretty sure that of the 20% you did observe, you've got most of the hedge fund managers, top execs, CEOs, athletes, etc.? We were conservative throughout; except for the public company execs we had pretty perfectly because they filed; I think on the others we erred on the side of conservative. So, I don't know. If we are at 20% that we can sort of put our fingers on, even if we were more aggressive my guess is we wouldn't get above 30%. Which is where you are going, I think. No, it's not. I'm just curious whether you think the missing groups are within the categories you are looking at or all pretty much outside the groups? Do you think you've got most of the hedge fund managers that are important, or do you just have some? The hedge fund, private equity, we're probably pretty good on. We probably don't include some money managers--those were harder to get numbers on. The public company executives we're pretty good on; my guess is the lawyers we are pretty good on. The celebrities I suspect we're light on. You probably didn't have Kim Kardashian. We had 100 celebrities making more than $1.4 million which I think is almost definitely on the low side. The top celebrities. You rely on things like Forbes's list; there are a lot of people. I mentioned Kim just because, you know, we are close friends and I'm sure she'll be on EconTalk soon. I'm kidding. I mention her because today was a day that it just came out that her marriage tragically is over. I've never watched the show; I was getting a haircut this morning and they had it in the background. My heart goes out to them. But she made a lot of money evidently on that experience, so she would be in the top 1% this past year. For certain.
22:08Okay, so what did you find? What are some of the patterns that are interesting and what did you learn from them? Among the patterns that were most interesting were that the CEOs weren't that unusual. This is the CEOs of non-Wall Stree, non-financial firms. Public companies, yes. The CEOs were just not unusual. Meaning? That their pay went up but it more or less over time went up like the rest of the top 1% or top .1%. So, this a view that corporate governance is broken, that boards are corrupt seems hard to understand when the CEOs are going up just like all the others. For example, top corporate lawyers saw their pay go up from say 1980 to date, partners at top law firms have increased their pay by about the same percentage as CEOs. It certainly is inconsistent with the theory that CEO pay at Main Street, publicly-traded companies is the source of the 1% growing. It doesn't refute the possibility that corporate governance is broken. Well, I agree--they are a very small fraction of the total--somewhere between 2-6% of the very top would come from public company executives. But the fact that their pay is not behaving any differently than the pay of bankers, or lawyers--they are all being driven by similar forces. Why would it be that this one group, corporate boards and CEOs are corrupt and are overpaying themselves--why would they be being paid roughly the same as people who are paid via arm's-length dealings? You'd think they could do even better than that. But of course a particular kind of cynic says: Well, yeah, all these people at the top have figured out--what Paul Krugman in his recent blog post called "The Oligarchy"--they've all figured out how to exploit the political system to enhance their own nests. It's possible. The other thing that strikes me there is hard to reconcile with that--and this is more anecdotal than data because the data are hard to find--but you do see similar patterns all over the world. I certainly see it with my students. Whether it's London or Asia now, the pay at the top for all these places for top talent do pay large numbers. We'll come back to oligarchical explanation. Let's stick with your finding. So, you found that for the CEOs, they seemed to be following the same pattern; another way to say it might be that it suggests there is a market for very talented people, and they are part of that. They are not different, not manipulating the market. That is basically the conclusion we came to. I'm sympathetic to that conclusion so I want to push back against it in a little bit. What else did you find in the data? Some remarkable things about hedge funds. That was amazing. Talk about that a little bit. This is one that was a lot of fun, when you talk about it. If you look at what the top hedge fund managers earn, in 2009, which was remember not a great year for the very top, the estimates that the top 25 hedge fund investors earned over $25 billion. They average $1 billion apiece. A fair amount of money. When you add up what all S&P500 CEOs earned, the S&P500 CEO in 2009 earned about $8 million each; but $8 million times 500 is $4 billion; and the 25 top hedge fund investors earned $25 billion. So that's five or six times as much. Mind-boggling number. Some might say that's more than enough. Whether it's more than enough is I guess a value judgment. What we were more interested in doing than thinking about the fairness issues, which are very hard--those can be argued in many ways--we were more interested in understanding what could explain this. And what could explain what really is the pervasiveness of this increase at the top. So, the CEOs went up, but not any more than these other groups; the bankers went up, the hedge fund managers obviously went up a lot; the lawyers went up. One of the more amusing things about disclosure is that, Eric Holder and other people going into the government--Attorney General of the United States--have to disclose what they earned. You know what he earned the year before he was Attorney General when he was a law partner? $3.3 million. Good figure. He was a .1% kind of guy; in fact, that probably put him in the .05%. Might make him a little more sensitive of the problem. Just trying my best. What explains hedge funds--the outliers might not be the right guys--certainly at the extreme. John Paulson had a couple of very good year where his 20% of the profits at his hedge fund were well into the billions. Technology, globalization, and incentivization. What are those three things? First, technology has changed tremendously over the last 30 years, particularly information technology, which allows you to scale your talent. Where do you see that? In the financial markets, with computers and computerized trading--you can push billions of dollars around quickly, and you couldn't do that so easily 30 years ago or 20 years ago. So, technology allows talent to scale; you see that in entertainment--with cable, which allows you do segment your audience and actually now gets more product to more people--that allows talent to scale. For lawyers, you are applying your talent to bigger deals. Technology has been very important, and it's been information technology which has really helped people scale. The second piece is globalization; and again, it allows you, if you are an investor you can invest not only in the United States but globally; if you are a corporation you can invest globally--it's allowed companies to outsource and that also allows talent to scale.
31:37And then the third thing that has also increased over time, call it incentivization, where hedge funds, the rise of hedge funds and private equity funds, the pay on that is 2 and 20, but the key part is where you get to keep 20% of your profits. Explain the 2 and 20. Maybe it's 1 and 20, but the 20 is almost always there, is that if you manage a private equity fund or a hedge fund, so if you are George Soros at a hedge fund, Steve Schwarzman at Blackstone, a private equity fund, people give you capital. So let's say you have $10 billion to invest. That's not easy to do--you have to convince a lot of really savvy people that you are trustworthy with their money--it's not just laying around. Again, the scalability--there are large pools of capital now, whether it's pension funds, sovereign wealth funds, whatever, that weren't so large 30 years ago. That's partially due to technology, partially to globalization. Partially due to growth. These big pools of money, and when either gets $10 billion to invest, the way they are compensated is they get an annual management fee, which is generally somewhere between 1-2% of assets under management. So, $100-$200 million a year. Real money. And then you get 20% of the profits. So, if George Soros has a good year and makes say a 50% return, so he's made $5 billion for his investors, he gets 20% of that $5 billion. So, he gets the $100-$200 million management fee, and then he gets a billion of the profit share. A lot of money. And if it goes down, so it's worth $8 billion or $6 billion after a year or two, he still gets the 1-2%, a smaller number now because it's a smaller base, and he doesn't get the kicker. Correct. And if he does that for a while, people start to cash out of the fund and don't give him any more money. But you still have to ask the question--in a really good year, I make maybe 15-20% on my no-load index mutual fund. There are many years I don't get close to that, obviously; and sometimes it's negative; and I pay the mutual fund company a very small amount to do the indexed fund because it's very cheap: competition, etc. So, the first puzzle is--if you can earn 50% people would like to give you money. The question is, how are they able to do that, and how many people are able to do that? So, that's where the evidence is a bit unclear. On the hedge fund side, the evidence of consistent outperformance is actually pretty weak. So, I think there are some people who do that very well, have some good years; and then they have some bad years. John Paulson is a nice example. He was the guy who made a huge amount of money on the mortgage debacle; and then he had another extremely good year. This year he is having a terrible year. But the puzzle is to draw skilled people into that activity, it's going to take into account that volatility, obviously, the rewards as people compete. There are a lot of people who would like to have that job. So, they are offering their skills--they'd be happy to take a half a percent, instead of taking 2 and 20 or 1 and 20, they'd be happy to take .5 and 10. Does that happen? And if not why not. Here's the problem. I do this in my class, and it's quite fun. This is similar for private equity and for hedge fund. You'd be willing to manage money for less; instead of 2 and 20, you'll take 1 and 10. So, I ask my students that, and a few of them raise their hands. And then I say: Okay, now switch positions. You are not a hedge fund manager; you are now a pension fund. Are you going to give Russ money? But I'm cheap! And nobody raises their hand. You ask them why, and they go, well, if he were any good, he'd be charging 2 and 20. If he's charging 1 and 10, he must be a loser. And there's some truth to that--I would be a loser. It's a market that clears; it doesn't clear on price. Because if you deviate downward, particularly on the 20% of the profits, that's a bad signal. You can lower your management fee a little bit; there you are not aligned. But when you deviate on the carry, that's a bad signal. That I think is why in these markets, private equity and hedge funds, very hard to deviate downwards. You can deviate upwards, and some people do. But deviating down is very hard. But it also has to be the case for that story to work that there also have to be a very small number of people who are capable of doing it. You are getting paid for talent. It begs the question: How did they get to 20? Why don't they make it 40? What I ask my students is, if it's just a signal, then you should charge 30, because then people will think you must be really good. And that can't be true. In venture capital, that's what happens. It doesn't keep rising, though. No, 30 is about as high as it gets. Right--it doesn't go to 40. You can't say: I'm even better than that guy; I get 40. You still have to have a track record; you still have to leave enough money for your investors relative to other alternatives that they are still willing to pay that premium. And you have to recognize the fact that although you don't want to give it to me and you'd rather give it to John Paulson, there are these bad years for him; and it means a lot of times you'll give him 20% of your winnings in the good years and in the bad years, he doesn't write you a check. He doesn't pay 20% of the losses. That is correct. Correct on hedge funds. Private equity funds are a little better because the private equity fund typically is out there for 10 or more years and you do net winners and losers within a fund. So the incentive alignment in private equity is a little bit better to my mind than the hedge funds; but it's still the case that you can have one fund that's terrible and then raise another fund 3 years later that turns out to be great and you don't net the first fund against the second fund.
40:17Related question, not out of your paper: if we thought of three different parts of our capital market in America--the investment bank part, the hedge fund part, and the private equity part--what are the magnitudes of how many people are in those businesses at the top and what share of total capital are they allocating? Any rough idea about that? In our paper our estimates were about similar size. We had about 3000 hedge fund investors in the .1% and about 3000 private equity and venture capital investors in the top .1%. So, the numbers of people were the same. The fees were sort of about the same order of magnitude. And this is all about 2004--my numbers, 2004 versus today might be a little bit higher. Sort of $25 billion, so they must be higher because you only have $25 billion for the hedge fund investors overall and we know the top 25 did that a couple of years ago. And that tells you something about how much money they have under management. We were conservative in the numbers; we estimated for the non-CEOs. In private equity and venture we had the same order of magnitude--$25-$30 billion. And what about Wall Street, investment banks? Wall Street we had the same order of magnitude: for the investment bankers, $28 billion. All three of those groups in roughly the same buckets. I would say today, the investment bankers have really been hit by three things--the crisis has made fewer investment bankers, fewer left, not doing as well, they tend to be very pro-cyclical. When the economy is doing well they do a lot more deals. The bankers I suspect are down a fair amount. Hedge fund and private equity investors, probably still doing okay. And when you said they are roughly the same magnitude, is it roughly right to say then that highly talented financial people on a per capita basis--those were total numbers for the groups--were the per capita gains to those folks and returns be roughly the same? You'd expect them to be if there is a market for talent. Obviously somebody running a hedge fund could go work for a private equity firm; someone running a private equity firm could go on to Wall Street. They obviously move around. They get specialized but they have similar opportunities. If there is a market you'd expect them to have similar compensation. I'm looking at the Forbes 400 in 2008, and, this is corroborating to what we talked about earlier: I've got 27 hedge fund investors out of 400; I've got 33 private equity investors; and I've got 29 real estate investors. So, roughly the same number in the Forbes 400; and by the way, that's over 20%. And that's wealth or income? Wealth. There's some alignment there, obviously. So, going back to your study--the CEOs did about the same as the total group itself. Were there any folks within the group who did particularly better than others? Are they all kind of moving up together? I think the hedge fund managers had this huge increase in the 1990s, so my sense is this would be true for private equity and for hedge funds. The money under management for example in private equity increased from 1986-2005 by a factor of 30-40 times. Of course, that was spread over a number of people, but there is a huge explosion in private equity; and there is also a similar explosion in hedge funds: $35 billion in 1991 to a trillion in 2004, and that's kept on going. Hedge fund and private equity managers really increased markedly over this period. And more than the CEOs. We are thrilled that people are funding new ventures, finding new capital if indeed they are doing it wisely. We want that to happen and we want the people who do it to do it well. I think the evidence on the private equity and venture capital industries is very good. I've got some other research on private equity and venture. Private equity, the returns there have consistently been better than the returns to the public markets; and that's net of fees. If you do it gross of fees they do a lot better. That suggests that the private equity investors are actually making their companies more efficient. I think venture capital has not been great in the last 10 years in terms of what they've delivered to their investors; venture capital is spectacular in the 1990s but I think the companies that venture capitalists fund tend to be the innovators that tend to have a lot of externalities that they don't capture. So the short answer is private equity and venture are actually quite good for society. The hedge funds are a little trickier, I think. Well, they are doing a lot of different things. Exactly. I think the fundamental point that should be emphasized is that unlike some activities in the marketplace, if you are really good at say funding new ventures or helping private equity enterprises, there is no limit to how much money people can give you. There is a market test. If you are successful and better than your peers, people will throw money at you. Some of it's luck; there's a role for randomness. You can be fooled by randomness. But in general, if you are consistently bad, you don't get to play. That's exactly what happens in private equity, venture, and hedge funds.
48:18Let's turn to Wall Street. Let me put a less cheerful hypothesis on the table and get your reaction. Starting in the 1990s, most investment banks--I think almost all of the big ones--went public. Why that is, is a question. One of the things that changed in the 1990s was we were in a period when it became more likely that the Federal government would bail you out if you lent money to bad investments. As opposed to making bad equity investments; by being a lender, starting with Continental Illinois in 1984 and then through the Mexican crisis in 1995 and you could argue Long Term Capital Management, the Federal government did not, for a whole bunch of reasons decided that lenders, if you were large, could get your money back, 100 cents on the dollar. That surely made it easier to borrow and lend; and that made it easier to leverage capital in that activity; and that in turn made it easier for executives in those businesses to gamble with other people's money rather than their own. Unlike the hedge funds and the venture capitalists and private equity who were clearly taking equity stakes, where they could lose everything. That suggests to me a depressing story where investment banks had a heads-I-win, tails-you-lose--lived in that world--and were able to grow very large and with much less risk to their well-being. And in turn, they allocated capital very poorly--trillions into the housing market for which many of them paid a very small price ex post. What do you think of that? I am not a big believer in that argument. Where do I start on that? Sorry--it's a long argument. I think that first of all the view that bankers did heads-I-win, tails-you-lose and that they thought that way, I think just doesn't make a whole lot of sense. Look at Bear Stearns and Lehman--Cayne at Bear Stearns, Fuld at Lehman--they both had hundreds of millions of dollars in Bear Stearns and Lehman stock. They lost a billion apiece, on paper. And I think if you asked them, would they do it over again, they'd say: No way. I think they believed in what they were doing and didn't think that what happened could possibly happen. They were surprised. A strange defense, for someone whose job it is to not be surprised. The CEO of an investment bank. Let me take your example--Fuld and Cayne--it's beautiful because they each lost about a billion when their stock values were wiped out, leaving them with almost the same amount as their paltry nest egg. A mere $500 million. Now, where did that come from? Be careful. Where do you get the $500 million? This is where there's been a lot of misinformation. Happy to learn that I'm misinformed, but here's the way that I've read the data. Their stocks--Bear Stearns I think peaked at 170 and then ended up crashing, started at 10, went down close to 3, close enough to zero that somebody who held it through that ride lost a lot of money. But of course it bounced around a lot before that and during that. Didn't go straight down. Fuld and Cayne sold when they could; and they didn't put it back into their own company. And they got some bonuses. And they didn't put it back into that one egg. Here's the missing link. Lucian Bebchuk has written about as much as they had back in. And it would be gauche to have nothing left in; you couldn't sell it all; and there's regulation against it. Let me tell you the missing insight there. Lucian gave this paper at a seminar and was completely at a loss when I mentioned this: much of the equity that Fuld and Cayne received was in the form of options and restricted stock. You know what the tax treatment is of options and restricted stock? I do not. You pay ordinary income tax on that. You know what ordinary income tax rates are in New York City? High. 50%--federal, state, and local. Now if you get $2 billion in restricted stock, what do you pay on that in taxes? A billion. And to pay those taxes, what do you have to do with that restricted stock? You have to sell it. So, if you sold a billion dollars in stock, you have to pay taxes. Not all of it. In the example I just gave you, all of it went to pay taxes. If I've got $2 billion of restricted stock, that's $2 billion of income--I owe a billion in taxes; I have to sell a billion of my stock to pay my stock to pay my taxes; I am left with a billion dollars of stock in company and that went to zero; and that went to zero. I end up with zero. So, why did they sell their stock along the way like that? They did, to pay their taxes. I'm not saying they ended up with nothing, which is the extreme from the example I gave you, but they ended up with far less than people like you or Lucian think they did because they are paying taxes of 50% on everything they've been granted. So the bottom line there is: I think Lucian has they took out as much as they lost in the crisis when the thing crashed. But after tax, they might have ended up with nothing but they certainly ended up with far less than you'd give them credit for given pre-tax. The $500--that is pre-tax. That's not the way Jimmy Cayne tells it in House of Cards, by William Cohan. He's interviewed in there, and he says: Well, I lost a billion, which is tough on my heirs; but he says he's left with half a billion. Okay. He's keeping score. He may have picked the pre-tax number for his own ego. I'm willing to accept that that's an inflated number; it's a great point about the taxes. He was there for a very long time; I guess Fuld was, too. Okay, point taken. The estimates Lucian would give you would be a billion versus a billion; Cayne would be half a billion versus a billion; I'm not all sure it was all from Bear Stearns; may have been from other investments. But fair enough. So, the answer is: It's not zero, which was the extreme I gave; but the answer is not the billion you started out with. Coming back to my main point, these people were not happy to lose at all. As you go lower down in the organization, the amount of money people had taken out actually decreases. Interesting. Remember who is making all the decisions on this; it's not necessarily the people at the top. It's the people lower and lower down, and as you go lower down, these people increasingly hadn't taken much out and ended up losing a huge amount.
57:28Going back to this question of what's the right narrative, which is the way I tend to think about it: When these were privately held firms, and they were investing their own money, they took less risk. That is not true. Let me give you a really interesting example which goes to the story that I'm telling that it was more or less the perfect storm and they kind of got surprised. Overconfident. Hubris. There was a partnership in the late 1920s that most of the partners, basically all of the partners' net worth was invested in the partnership. The partnership decided to put together a leveraged investment vehicle. They put up 50% of the partnership's capital into that investment vehicle. It was leveraged. They sold this in 1928 and when the market crashed in 1929 this partnership almost went bankrupt. Took it more than 20 years to recover. And remember this is partners' own capital; there is no FDIC or anything. It was Goldman Sachs. And they almost didn't live to tell the tale. Well, that happens. People make mistakes. I think this is what happened in the 2006-2007 time period. And it was exacerbated by the fact that the SEC let them take on more leverage. No doubt. That I think was a decision in 2004, where the leverage ratios were allowed to increase substantially. But I don't think--the view that it was heads I win, tails you lose just doesn't explain it. Because these sorts of events have happened really through all time. You had the Panic of 1873, very similar, people losing their own money; 1907, people losing their own money; you had 1928, 1929 people losing their own money; and then you had 2007-2008, which looks a whole lot like those other episodes. My view on this, the capitalist system, for better or for worse you get these periods where people become, whether it's overly optimistic or they just decide to take on extra risk and then they get things wrong and then you get a big downturn. So, you don't think that the policy response in the past 30 years to these failures, especially in 2008 where every financial institution that was large, its creditors were bailed out 100 cents on the dollar with the exception of Lehman and I think Wachovia, which I think the FDIC--podcast with Vincent Reinhart--there was one bank, wasn't a Fed intervention, it was an FDIC intervention that actually made the creditors take a haircut--that is, accept less than they were promised for a fixed investment like bonds. You don't think there is a moral hazard issue there? You don't think that it makes it worse, or just that it's not big enough to explain the mess itself? I just don't think it's big enough. Do you think it has an effect? Or do you think it's irrelevant? I don't know. Another think that was interesting about the crisis in this regard is that obviously the mortgage-backed is the one that blew up. That would be consistent with your story. But the leveraged loan market going back to private equity--that market actually did just fine. People were saying there were going to be a huge number of defaults by the private equity investors and by the private equity fund at companies and they just didn't happen because they learned their lesson in the late 1980s and structured deals in a more responsible way. The heads-I-win, tails-you-lose story would have said: You should have seen these problems everywhere. And you really just saw it in the mortgage market, which was I think was an innovation gone awry. The mortgage market and the [?] market were both innovations that were relatively new and people got it wrong. Could be. Explain that leveraged loan market--what is that? When you did a leveraged buyout and there was record buyout volume in 2006, 2007, and 2008, banks and other investors made highly leveraged loans to the companies. And they were risky; they had high interest rates; and very few of them defaulted. So, my explanation of that, to be consistent with my story, would be that those lenders--and correct me if I'm wrong--have less political pull than the folks who got rescued in the bailouts of 1995, etc. That they were not too big to fail. I think that would be wrong. The same people were buying that as were buying the mortgage stuff. It is--it's the same large investment banks doing those large finance deals? Yes. Well, that's counter-evidence. I agree with that. That's a provocative example I need to look at. The puzzle for me is that I think--my favorite example is Riccardo Rebonato, Chief Risk Officer of the Royal Bank of Scotland, interviewed him about the book he wrote but not about the crisis--his book is The Plight of the Fortune Tellers, where he explains how bad we are at estimating risk and how bad our understanding of uncertainty is and how the Value at Risk model, we really don't understand it. He writes that book in 2005, 2006; and he's the Chief Risk Officer. He wasn't fooled. But for some reason when he tapped his boss on the shoulder, presumably his boss said: Leave me alone. Maybe it was a human failing. But maybe the incentives weren't there that hadn't been there in the past. Interesting. I would argue the same thing happened in 1929, 1907; they weren't being bailed out then. In all three cases what would the right answer be? Higher capital requirements. We would probably agree on the right answer; we might not agree on what's causing it. I hope we can come back and talk about that, because you've written some interesting stuff on how to reduce the probability of a future mess.