Scheidel, Lo, and Tirole longlisted for FT & McKinsey Business Books of the Year

Scheidel Great Leveler jacketThe longlist for the Financial Times & McKinsey Business Books of the Year Award was announced on August 14th, and we’re thrilled that once again the list of finalists includes several Princeton University Press books:

The Great Leveler by Walter Scheidel, the first book to chart the crucial role of violent shocks in reducing inequality over the full sweep of human history around the world.

Economics for the Common Good by French winner of the Nobel prize in economics, Jean Tirole, a passionate manifesto for a world in which economics, far from being a “dismal science,” is a positive force for the common good.

Adaptive Markets by Andrew Lo, a new, evolutionary explanation of markets and investor behavior.

Economics for the Common Good by Jean TiroleThe shortlist for this highly distinguished prize will be announced on September 19th. The winner of the Business Book of the Year Award will be awarded £30,000, and £10,000 will be awarded to each of the remaining shortlisted books.

Take a look at all the finalists for this honor during the past decade here.

LoA heartfelt congratulations to our authors.

 

 

 

 

Gary Saul Morson & Morton Schapiro: How the study of economics can benefit from the humanities

CentsEconomists often act as if their methods explain all human behavior. But in Cents and Sensibility, an eminent literary critic and a leading economist make the case that the humanities, especially the study of literature, offer economists ways to make their models more realistic, their predictions more accurate, and their policies more effective and just. Gary Saul Morson and Morton Schapiro argue that economists need a richer appreciation of behavior, ethics, culture, and narrative—all of which the great writers teach better than anyone. Original, provocative, and inspiring, Cents and Sensibility brings economics back to its place in the human conversation. Read on to learn more about how the study of economics is lacking, the misreading of Adam Smith, and how the humanities can help.

You clearly think that economics as traditionally practiced is lacking in fundamental ways. Why?
We believe that economic models could be more realistic, their predictions more accurate, and their policies more effective and just, if economics opened itself up to learning from other fields.

But don’t economists already work on subjects within the typical domain of such disciplines as psychology, sociology, anthropology, and history, among others?
It is true that economists apply their models very widely, but they often expropriate topics rather than sincerely engage with other fields. Too often economists act as if other disciplines have the questions, and economics has the answers. It is one thing to tread on the territory of another discipline; it is quite another to be willing to learn from it. Economists have often been imperialistic, presuming that the subject matter of other disciplines could be put on a “sound basis” if handled by economic models. They rarely ask whether the methods and assumptions of other disciplines might help economics. We need a dialogue, and a dialogue goes both ways.

You say that economics can be improved by interaction with the humanities, and especially the study of literature. In what ways does economics fall short so that an understanding of literature might help?
Economists have an especially hard time in three sorts of situations: when culture plays an important role, since one cannot mathematize culture; when contingency prevails and narrative explanation is required; and when ethical problems irreducible to economic models are important. For instance, whether to have a market in kidneys—one topic we address—is not a question that can be adequately addressed solely in economic terms. Economic thinking has something useful to say in many such cases, but not everything.  Great works of literature have offered the richest portraits of human beings we have. If social scientists understood as much about human beings as the great novelists, they could have produced pictures of human beings as believable as those of Jane Austen, George Eliot, or Leo Tolstoy, but none has even come close. The great novelists, who were often keen thinkers who discussed the complexities of human feeling and behavior, must have known something! They also produced the subtlest descriptions of ethical problems we have.

Isn’t economic imperialism the legacy of Adam Smith, the founder of the discipline?
Not at all. Economists, who seldom read The Wealth of Nations and rarely ask students to do so either, present a version of Adam Smith that is largely fictional. A thinker with an immensely complex sense of human nature, and who insisted that human beings care for others in ways that cannot be reduced to self-interest, is presented as a founder of rational choice theory, which presumes the opposite. What has happened is that a few Smithian ideas have been represented as the whole, and then a model based on them alone has been constructed and been attributed to him. While Adam Smith is often invoked to justify a simplistic view of human behavior guided by rational self-interest, and of economic policies that reject any interference with the free functioning of markets, his work was much more nuanced and sophisticated than that. To truly understand The Wealth of Nations, one must also read his complementary volume, The Theory of Moral Sentiments. Together, they provide the kind of far-reaching, inclusive economics celebrated in this book—an economics that takes other subjects seriously and embraces narrative explanations.

Don’t those two books contradict each other?
The idea that they do, and the question how the same author could have written them both, is often called “the Adam Smith problem.” In fact, the problem arises only when one misreads Smith. We offer a solution to the Adam Smith problem, which also shows how his thought looks forward to the great novelists to come.

You believe that narratives could teach economics a great deal. Is that why you argue that the humanities could be so useful in making economics more relevant?  How exactly does narrative help?
Stories are important, especially those told by the great realist novelists such as Tolstoy, Dostoevsky, Chekhov, and Austen. They help in at least two ways. First, in a world where genuine contingency exists, it is necessary to explain events narratively, and there are no better models for narratives about people in society than those in great novels. Second, novels foster empathy. Other disciplines may recommend empathy, but only novels provide constant practice in it. When you read a great novel, you identify with characters, inhabit their thought processes from within, and so learn experientially what it is to be someone else—a person of a different culture, class, gender, or personality. In a great novel you inhabit many points of view, and experience how each appears to the others. In this way, great novels are a source of wisdom. They appreciate people as being inherently cultural while embracing ethics in all its irreducible complexity.

That doesn’t sound like the way English courses are currently taught or accord with the currently predominant premises of literary theory.
Quite so. We are stressing a particular version of the humanities, what we think of as “the best of the humanities.” In a variety of ways, the humanities have been false to their core mission, which may be why so many students are fleeing them. In addition to the dominant trends of literary theory, we have witnessed a series of “spoof” disciplines, which purport to be humanistic but are actually something else. Sociobiological criticism, digital humanities, and other such trends proceed as if literature were too old fashioned to matter, and one has to somehow restore its importance by linking it—how doesn’t matter much—to whatever is fashionable. They all too often dehumanize the humanities, reducing their value not just to economics but to other fields as well. We celebrate, and recommend economists consider, the humanities at their best.

Are there any particular subjects within economics where engagement with the “best” of the humanities would be especially worthwhile?
There is a wide range of areas covered in the book—from economic development, to the economics of higher education, to the economics of the family—for which we believe a genuine dialogue between the humanities and economics is useful. We offer case studies in each of these areas, with some unanticipated results. We don’t pretend to conclude that dialogue in our book; we instead seek to get it started in a serious way.

Where do you see the dialogue of the two cultures leading?
The point of a real dialogue is that it is open-ended, that you don’t know where it will lead. It is surprising, and that is what makes it both stimulating and creative.

Gary Saul Morson is the Lawrence B. Dumas Professor of the Arts and Humanities and professor of Slavic languages and literatures at Northwestern University. His many books include Narrative and Freedom, “Anna Karenina” in Our Time, and The Words of Others: From Quotations to Culture. Morton Schapiro is the president of Northwestern University and a professor of economics. His many books include The Student Aid Game. Morson and Schapiro are also the editors of The Fabulous Future?: America and the World in 2040.

Elizabeth Currid-Halkett: Conspicuous consumption is over. It’s all about intangibles now

In 1899, the economist Thorstein Veblen observed that silver spoons and corsets were markers of elite social position. In Veblen’s now famous treatise The Theory of the Leisure Class, he coined the phrase ‘conspicuous consumption’ to denote the way that material objects were paraded as indicators of social position and status. More than 100 years later, conspicuous consumption is still part of the contemporary capitalist landscape, and yet today, luxury goods are significantly more accessible than in Veblen’s time. This deluge of accessible luxury is a function of the mass-production economy of the 20th century, the outsourcing of production to China, and the cultivation of emerging markets where labour and materials are cheap. At the same time, we’ve seen the arrival of a middle-class consumer market that demands more material goods at cheaper price points.

However, the democratisation of consumer goods has made them far less useful as a means of displaying status. In the face of rising social inequality, both the rich and the middle classes own fancy TVs and nice handbags. They both lease SUVs, take airplanes, and go on cruises. On the surface, the ostensible consumer objects favoured by these two groups no longer reside in two completely different universes.

Given that everyone can now buy designer handbags and new cars, the rich have taken to using much more tacit signifiers of their social position. Yes, oligarchs and the superrich still show off their wealth with yachts and Bentleys and gated mansions. But the dramatic changes in elite spending are driven by a well-to-do, educated elite, or what I call the ‘aspirational class’. This new elite cements its status through prizing knowledge and building cultural capital, not to mention the spending habits that go with it – preferring to spend on services, education and human-capital investments over purely material goods. These new status behaviours are what I call ‘inconspicuous consumption’. None of the consumer choices that the term covers are inherently obvious or ostensibly material but they are, without question, exclusionary.

The rise of the aspirational class and its consumer habits is perhaps most salient in the United States. The US Consumer Expenditure Survey data reveals that, since 2007, the country’s top 1 per cent (people earning upwards of $300,000 per year) are spending significantly less on material goods, while middle-income groups (earning approximately $70,000 per year) are spending the same, and their trend is upward. Eschewing an overt materialism, the rich are investing significantly more in education, retirement and health – all of which are immaterial, yet cost many times more than any handbag a middle-income consumer might buy. The top 1 per cent now devote the greatest share of their expenditures to inconspicuous consumption, with education forming a significant portion of this spend (accounting for almost 6 per cent of top 1 per cent household expenditures, compared with just over 1 per cent of middle-income spending). In fact, top 1 per cent spending on education has increased 3.5 times since 1996, while middle-income spending on education has remained flat over the same time period.

The vast chasm between middle-income and top 1 per cent spending on education in the US is particularly concerning because, unlike material goods, education has become more and more expensive in recent decades. Thus, there is a greater need to devote financial resources to education to be able to afford it at all. According to Consumer Expenditure Survey data from 2003-2013, the price of college tuition increased 80 per cent, while the cost of women’s apparel increased by just 6 per cent over the same period. Middle-class lack of investment in education doesn’t suggest a lack of prioritising as much as it reveals that, for those in the 40th-60th quintiles, education is so cost-prohibitive it’s almost not worth trying to save for.

While much inconspicuous consumption is extremely expensive, it shows itself through less expensive but equally pronounced signalling – from reading The Economist to buying pasture-raised eggs. Inconspicuous consumption in other words, has become a shorthand through which the new elite signal their cultural capital to one another. In lockstep with the invoice for private preschool comes the knowledge that one should pack the lunchbox with quinoa crackers and organic fruit. One might think these culinary practices are a commonplace example of modern-day motherhood, but one only needs to step outside the upper-middle-class bubbles of the coastal cities of the US to observe very different lunch-bag norms, consisting of processed snacks and practically no fruit. Similarly, while time in Los Angeles, San Francisco and New York City might make one think that every American mother breastfeeds her child for a year, national statistics report that only 27 per cent of mothers fulfill this American Academy of Pediatrics goal (in Alabama, that figure hovers at 11 per cent).

Knowing these seemingly inexpensive social norms is itself a rite of passage into today’s aspirational class. And that rite is far from costless: The Economist subscription might set one back only $100, but the awareness to subscribe and be seen with it tucked in one’s bag is likely the iterative result of spending time in elite social milieus and expensive educational institutions that prize this publication and discuss its contents.

Perhaps most importantly, the new investment in inconspicuous consumption reproduces privilege in a way that previous conspicuous consumption could not. Knowing which New Yorker articles to reference or what small talk to engage in at the local farmers’ market enables and displays the acquisition of cultural capital, thereby providing entry into social networks that, in turn, help to pave the way to elite jobs, key social and professional contacts, and private schools. In short, inconspicuous consumption confers social mobility.

More profoundly, investment in education, healthcare and retirement has a notable impact on consumers’ quality of life, and also on the future life chances of the next generation. Today’s inconspicuous consumption is a far more pernicious form of status spending than the conspicuous consumption of Veblen’s time. Inconspicuous consumption – whether breastfeeding or education – is a means to a better quality of life and improved social mobility for one’s own children, whereas conspicuous consumption is merely an end in itself – simply ostentation. For today’s aspirational class, inconspicuous consumption choices secure and preserve social status, even if they do not necessarily display it.Aeon counter – do not remove

Elizabeth Currid-Halkett is the James Irvine Chair in Urban and Regional Planning and professor of public policy at the Price School, University of Southern California. Her latest book is The Sum of Small Things: A Theory of the Aspirational Class (2017). She lives in Los Angeles.

This article was originally published at Aeon and has been republished under Creative Commons.

The Financial Diaries

FinancialThe Financial Diaries by Jonathan Morduch and Rachel Schneider details the results of a groundbreaking study they conducted of 235 low- and middle-income families over the course of one year. What they found is that the conventional life-cycle method of approaching finances, wherein a family saves steadily to prepare for eventual retirement, is unrealistic for many. This book combines hard facts with the personal stories of people struggling to make ends meet, even in a time when America is experiencing unprecedented prosperity. You’ll meet a street vendor, a tax preparer, and many more as Schneider and Morduch challenge popular assumptions about how Americans earn, spend, borrow, and save. Read on to learn more about the everyday challenges of a casino dealer from central Mississippi.

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Janice Evans has worked at the Pearl River Resort— a family-friendly destination on the Choctaw reservation in central Mississippi with water slides, a spa, two golf courses, a steakhouse, and a casino—for close to twenty years, since she was in her mid-thirties. She works the night shift, starting at 8am and finishing up at 4am. As a single, African American mother with a high school degree, she makes $8.35 per hour, but in a good week she can double that in tips. Customers can put chips in her “toke box,” and at the end of each shift they are collected and counted; the equivalent amount in dollars is then added to Janice’s next paycheck. She does well during the summer months, but fall is much slower. Her income also rises and falls based on where the local college football team is playing that year—when they play near Pearl River people often come to the casino after a game, and when they don’t the casino does not get that business. Over the course of the year Janice makes just over $26,000, or an average of about $2,200 a month. However, due to the fluctuating income from tips, her actual take home pay each month can vary from around $1,800 to approximately $2,400. That represents a 30% deviation between paychecks. Just before the study began, Janice’s son Marcus was laid off from his maintenance job when his employer lost a contract; as a result, he and his three-year-old daughter moved in with Janice. Since he no longer had an income, he qualified for food stamps, an average of $125/month, but this income was unsteady as well: at one point the local social services agency mistook Janice’s income for Marcus’s and canceled his food stamps. It took two months to get them back. And while he also qualified for unemployment benefits, several months passed before the first check arrived. Altogether, the benefits boosted the household’s net income to $33,000, but with the increased funds came increased inconsistency. Whereas before Janice’s income swung 30%, it now swung 70% from high to low months. Given the nature of Janice’s work in a seasonal, low-skill, tipped job and the unreliability of Marcus’s benefits, you might assume that her family’s income would be among the most erratic of the 235 households studied in the U.S. Financial Diaries. In fact, it’s not—the degree of inconsistency in Janice’s household was on par with most families that the authors got to know throughout the course of their study. Morduch and Schneider’s study of families who struggle with income volatility revealed new insights into how Americans make money, borrow, spend, and save.

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To learn more, pick up a copy of The Financial Diaries by Jonathan Morduch and Rachel Schneider.

Carol Graham on the optimism gap between rich and poor

GrahamThe Declaration of Independence states that all people are endowed with certain unalienable rights, and that among these is the pursuit of happiness. But is happiness available equally to everyone in America today? How about elsewhere in the world? In Happiness for All, Carol Graham draws on cutting-edge research linking income inequality with well-being to show how the widening prosperity gap has led to rising inequality in people’s beliefs, hopes, and aspirations. Recently, she took the time to answer some questions about her new book.

Why did you decide to write a book on unhappiness in the U.S.?

CG: This was a first for me, as I have spent much of my career exploring and writing about the causes and potential solutions to poverty and inequality challenges in developing countries. I took a modest change in direction about a decade ago and began to explore the determinants of happiness in countries and cultures around the world. This turn was driven by my findings of deep frustration among upwardly mobile low-income respondents in emerging market economies. What was most notable was the remarkably consistent patterns in the correlates of happiness across countries of all levels of development. I then found that happier people tended to have happier and more productive lives, and wrote one of the early papers on what happiness ’causes.’ Those findings have since been confirmed by several subsequent studies. Meanwhile, despite (or because of?) my grounding in development economics and origins in Peru, I have been increasingly concerned by the very large gaps between the incomes, opportunities, and lives of the rich and poor in the U.S. – a country with a reputation as the land of opportunity. As such, I decided to explore if and how those gaps were mirrored by differences in well-being and ill-being across the same groups in this book.

What is different about this book from the many recent studies of rising inequality of incomes and opportunities in the U.S.?

CG: While many economists, including me, have been discussing and writing about the downsides of increasing inequality in the U.S., interest in the topic was largely confined to academic audiences until very recently. And while the debate surrounding the 2016 elections brought inequality to the public’s attention, public understanding of actual trends in inequality and their implications remains very limited, in large part because of the complexity of the metrics used to measure it, such as Gini coefficients and 90/10 ratios. In the book I try and tell the same story from the perspective of well-being metrics, in the hopes that it might be a better way to explain the implications of inequality for economists and non-economists alike. One of the little known channels that I highlight is a beliefs and behaviors channel via which high levels of inequality – and large differences between those at the top of the distribution and the rest of the population – can act as a disincentive to investments in the future. This is because ‘success,’ as defined by the lives of those at the top, seems (and often is) out of reach for those at the bottom, making them less likely to make the difficult trade-offs to forego current consumption for the ‘promise’ of future outcomes.

What are your key findings for the land of the American Dream?

CG: Most markers of well and ill-being, ranging from life satisfaction to stress, are more unequally shared across the rich and the poor in the U.S. than they are in Latin America, a region long known for high levels of inequality. The most remarkable finding is that the belief that hard work can get you ahead in the future – a classic American dream question – is the most unequally shared metric. The poor in Latin America are almost four times as likely to believe that hard work will get them ahead than are the poor in the U.S. In contrast, the rich in the U.S. are more likely to believe that hard work will get them ahead than the rich in Latin America. Meanwhile, stress, a marker of ill-being, is significantly higher among the poor in the U.S. than the poor in Latin America. The stress which is typically experienced by the poor is related to constant negative shocks which are beyond individuals’ control. This kind of stress makes it hard to plan ahead, much less invest in the future, and is distinct from stress that is associated with goal achievement – which is more common among those with more means and control over their lives. These findings highlight very different incentives – and capabilities – for making investments in the future across the rich and the poor in the U.S.

Were there any other surprises?

CG: The most surprising of the findings were large gaps in optimism across racial cohorts, which did not run in the expected direction. In the fall of 2015 – about the same time as the riots against police violence against blacks in cities such as Ferguson and Baltimore – I found that the most optimistic group among the poor were poor blacks, followed by poor Hispanics. In contrast, poor whites showed signs of deep desperation. At roughly the same time, Anne Case and Angus Deaton published a study highlighting rising U.S. mortality rates driven by preventable deaths among uneducated middle aged whites. Since then, I have matched my desperation data/lack of optimism data with the mortality rate trends – by race and place – and find that the markers correspond quite closely. The most desperate people and places are poor and vulnerable middle class whites in the rust belt, where available jobs are shrinking due to the hollowing out of manufacturing and people are extremely isolated by distance and climate. In contrast, cities, which are more racially diverse, are healthier, more hopeful, and happier. These trends help explain some of the anger and desperation that drove the 2016 election results in the U.S. and also mirror those which influenced the U.K.’s Brexit referendum and an unexpected (and economically costly) decision to leave the European Union.

What are the potential solutions?

CG: There is no magic bullet to the narrowing the gaps between the lives – and well-being – of the rich and the poor in the U.S. And while desperation among poor and downwardly mobile whites is clearly a concern, there are still momentous challenges facing poor – if more optimistic – minorities. In the book I highlight a range of policies – from better vocational training, to more widely available pre-school and quality public education, to improving our safety net so that it does not stigmatize recipients and at the same time leave the non-working poor behind. I also provide examples – from novel experimental data – of interventions which raise aspirations and hope among the poor and disadvantaged, thereby encouraging investments in the future. I conclude by highlighting the important role that well-being metrics can and should play in official statistics, by tracking the health and well-being of our society, as the U.K. is already doing. The metrics can, for example, identify pockets of desperation before mortality rates increase, and highlight community level practices which increase well-being among the vulnerable, among many other things.

GrahamCarol Graham is the Leo Pasvolsky Senior Fellow at the Brookings Institution and College Park Professor at the University of Maryland’s School of Public Policy. Her books include The Pursuit of Happiness: An Economy of Well-BeingHappiness around the World: The Paradox of Happy Peasants and Miserable Millionaires, and Happiness for All? Unequal Hopes and Lives in Pursuit of the American Dream.

In memory of William Baumol

Princeton University Press is saddened to learn of the passing of the great American economist, William Baumol. Baumol was the Harold Price Professor of Entrepreneurship and Academic Director of the Berkley Center for Entrepreneurship and Innovation in the Stern School of Business at New York University; senior economist and professor emeritus at Princeton University, and a prolific author. He will be remembered for his numerous contributions to the study of innovation and economic growth, including a famous theory known as Baumol’s cost disease, recalled here.

Kenneth Rogoff: The Compactness of Big Bills

Today in our blog series by Kenneth Rogoff, author of The Curse of Cash:

From Rachel Maddow of MSNBC, comes a video story marvelously explaining why criminals, tax evaders, and corrupt official so love large denomination notes. Here, an apparently corrupt Nigerian official (who pleads innocence) finds $100s very convenient for stashing cash. The story comes at the top of the show.

I am grateful to Larry Kintisch of Blauvelt NY for drawing my attention to this story. Yes, there is a world of difference between a “less-cash society” as my book argues, and a cash-less society that the cash lobby likes to point to as a scare tactic for maintaining the absurd status quo.

The paperback edition of The Curse of Cash: How Large Denomination Bills Aid Tax Evasion and Crime and Constrain Monetary Policy will be coming out early this summer; now with an analysis of Indian demonetization and other issues that have arisen in the past year.

Read other posts in the series here.

Andrew Lo on Adaptive Markets: Financial Evolution at the Speed of Thought

Half of all Americans have money in the stock market, yet economists can’t agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe. In this groundbreaking book, Andrew Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist. Adaptive Markets shows that the theory of market efficiency isn’t wrong but merely incomplete. Lo’s new paradigm explains how financial evolution shapes behavior and markets at the speed of thought. An ambitious new answer to fundamental questions in economics, Adaptive Markets is essential reading for anyone who wants to know how markets really work. We asked him to explain the Adaptive Markets Hypothesis, the strengths and limitations on the current theories, and how this new thinking can be practically applied.

What led you to write this book?

AL: Ever since I was a graduate student in economics, I’ve been struggling with the uncomfortable observation that economic theory doesn’t seem to work in practice. As elegant as this theory is, there are so many examples where the data just don’t support the theory that, after a while, I started wondering just how useful our theories were. For example, stock market prices don’t follow random walks, market prices don’t always seem rational, and people often make poor decisions, especially when it comes to financial matters. But it takes a theory to beat a theory. Rather than just criticizing existing theories, I decided to develop an alternative—this book describes the personal journey I took to arrive at that alternative, which I call the Adaptive Markets Hypothesis.

What’s the Adaptive Markets Hypothesis?

AL: The Adaptive Markets Hypothesis is my solution to the longstanding debate in financial economics between two competing camps. One camp consists of the disciples of the Efficient Markets Hypothesis, who believe that investors are rational decision makers and market prices fully reflect all available information. The opposing camp consists of the psychologists and behavioral economists who believe that investors are irrational and market prices are driven by “animal spirits.” It turns out that both camps have correctly captured certain aspects of human behavior, but neither camp offers a complete picture of how investors and markets behave. The Adaptive Markets Hypothesis fills this gap.

How?

AL: By drawing on recent research in psychology, neuroscience, evolutionary biology, and artificial intelligence, I show that human behavior is the result of several different components of the brain, some of which produce rational behavior while others produce more instinctive emotional behavior. These components often work together, but occasionally they compete with each other. And for obvious evolutionary reasons, rationality can be trumped by emotion and instinct when we’re confronted with extreme circumstances like physical threats—we “freak out.” The problem is that these hardwired responses to physical threats are also triggered by financial threats, and freaking out is generally not the best way to deal with such threats. Therefore, investors and markets have a split personality: sometimes they’re quite rational but every so often, they freak out.

Are you suggesting that the Efficient Markets Hypothesis, which dominates financial thinking today, is wrong?

AL: No! On the contrary, the Efficient Markets Hypothesis is one of the most useful, powerful, and beautiful pieces of economic reasoning that economists have ever proposed. Generations of investors and portfolio managers have been saved from bad investment decisions because of the Efficient Markets Hypothesis, which says that if something seems too good to be true, it probably is. The Efficient Markets Hypothesis is not wrong; it’s merely incomplete. Its focus is the behavior of investors and markets in normal business environments, where the “wisdom of crowds” rules the day. What’s missing is the “madness of mobs,” when investors are reacting emotionally and instinctively in response to extreme business environments—good or bad—leading either to irrational exuberance or panic selling. The Adaptive Markets Hypothesis provides a more complete framework in which both types of behaviors are possible. The combination of these behaviors yields a much richer set of implications for price dynamics, investment strategies, risk management, and financial regulation.

Who is the intended audience for this book?

AL: My intention was to write this book for the general reader, but only time will tell whether or not I’ve succeeded. In fact, I’m hoping that there’s something for everyone in this book. For example, readers wondering whether or not it’s possible to beat the stock market using mathematical models will want to read Chapter 2, “If You’re So Smart, Why Aren’t You Rich?” For readers already convinced that it’s possible and want to understand the neuroscientific basis of irrational behavior, they’ll want to read Chapter 3, “If You’re So Rich, Why Aren’t You Smart?” No book on finance would be complete without a discussion of how the recent financial crisis could have happened to us—a country with one of the most sophisticated financial systems in the world—and that’s Chapter 9, “Fear, Greed, and Financial Crisis.” And for readers interested in getting a glimpse of the future of the financial industry and the amazing things that can be accomplished with finance if used properly, there’s Chapter 12, “To Boldly Go Where No Financier Has Gone Before.” Although the book is based on my academic research, I’ve worked hard to translate “academic-speak” into plain English, using simple analogies and real-life examples to make the research come alive. In fact, there’s not a single equation or mathematical formula in the book, which is no easy feat for someone from MIT!

In Adaptive Markets you take an interdisciplinary view of financial markets, bringing in cognitive neuroscience, biology, computer science, and engineering. How did you come to bring all of these seemingly disparate fields together and why is that important?

AL: Although I do enjoy learning new things and have broad-ranging interests, when I started my academic career as a financial economist, I had no interest or intention in doing “interdisciplinary” research. I was perfectly happy spending my days and nights working on traditional neoclassical financial economics—portfolio theory, derivatives pricing models, asset pricing models, financial econometrics, and so on. But the more I tried to fit financial theories to data, the more frustrated I became that these theories performed so poorly. So I started trying to understand why the theories broke down and how they could be fixed. I began by studying behavioral economics and finance, which led me to psychology, which then to the cognitive neurosciences, and so on. I was dragged—sometimes kicking and screaming—from one field of study to the next in my quest to understand why financial markets don’t work the way we think (and want them to). This process ultimately led me to the Adaptive Markets Hypothesis, which is a very satisfying (for me, at least) integration of various disciplines that have something to say about human behavior. I’m especially pleased by the fact that Adaptive Markets reconciles the two competing schools of thought in financial economics, both of which are compelling in their own right even though they’re incomplete.

Why do we need to understand the evolution of finance?

AL: Many authors and academics will use evolution as a metaphor when referring to the impact of change. In Adaptive Markets, I use evolution quite literally because financial markets and institutions are nothing short of evolutionary adaptations that Homo sapiens has developed to improve our chances of survival. Therefore, if we really want to understand how the financial system works, how it changes over time and circumstances, and what we can do to improve it, we need to understand the evolution of finance. And unlike animal species, which evolve from one generation to the next, the financial system evolves at the speed of thought.

You argue that economics wishes it were more like the hard science of physics where 99% of all observable phenomena can be explained with three laws. Will we ever have a complete understanding of how financial markets function?

AL: It’s true that most economists—myself included—suffer from a psychological disorder called “physics envy.” We wish we could explain 99% of economic behavior with three laws like the physicists but this is a pipe dream. The great physicist Richard Feynman put it best when he said, “Imagine how much harder physics would be if electrons had feelings!” I tell all my students at the start of the semester that all economic theories are approximations to a much more complex reality, so the key question for investors and portfolio managers is not “is the theory correct?” but rather, “how good is the approximation?” The answer to this question lies largely in the environment, which plays a huge role in evolutionary theories. Whether we’ll ever be able to develop a truly complete theory of human behavior—and, therefore, how financial markets function—is hard to say. But I do believe that we can get much closer to that complete theory through the Adaptive Markets Hypothesis.

How can investors and portfolio managers incorporate the Adaptive Markets Hypothesis into their investment philosophies?

AL: The Adaptive Markets Hypothesis has a relatively straightforward but sweeping implication for all investment philosophies, and that has to do with change. During normal business environments, the principles of Efficient Markets are an excellent approximation to reality. For example, from the 1930s to the early 2000s, a period where the U.S. stock market had relatively consistent average returns and volatility, a long-only passive investment strategy of 60% stocks and 40% bonds produced pretty decent returns, particularly for those who were investing over a 10- or 20-year horizon. The problem is that this approach doesn’t always work. When market conditions change and we experience large macro shocks like the financial crisis of 2008, then simple heuristics like 60/40 no longer work as well because financial markets have changed in their dynamics. Today’s markets are now much more responsive to intervention by governments and their central banks and punctuated by the irregular cycle of fear and greed. So since 2007 and 2008, we’ve seen a very different market dynamic than over the previous six decades. The point of Adaptive Markets is not simply to be wedded to any static theory, but rather to understand how the nature of markets can change. And once it does change, we need to change with it. John Maynard Keynes put it best when, in responding to criticism that he flip-flopped on the gold standard, he said, “When the facts change, sir, I change my mind. What do you do?”

Can you give an example of how change might impact today’s investors?

AL: One important implication of Adaptive Markets for investors and portfolio managers is that passive investing is changing and we have to adapt. John Bogle—the founder of the Vanguard Group and the father of passive investing and index funds—had an incredibly important insight in the 1970s which he calls the “Cost Matters Hypothesis:” reducing trading costs can have a huge impact on wealth accumulation. Bogle has done more for the individual investor than anyone else I can think of; he democratized the investment process. Thanks to technological innovations like automated trading, electronic market-making, and big data analytics, we’re ready to take the next evolutionary step that builds on Bogle’s legacy. For example, like the trend in healthcare towards personalized medicine, we can now create personalized indexes that are passive portfolios designed to achieve specific goals for a given individual. You might be more risk tolerant than your neighbor so your portfolio will have more equities, but because you work in the financial industry and she works in big pharma, your personalized portfolio will have fewer financial stocks and hers will have fewer biopharma stocks. Also, personalized indexes can manage the risk more actively to suit an individual’s threshold of “pain.” Current financial wisdom criticizes investors who don’t invest for the long run, and I’ve always thought such criticism to be terribly unfair. After all, how easy is it for someone to stick with an investment that’s lost 50% of its value over just a few months? Well, that’s exactly what happened between the fourth quarter of 2008 and the first quarter of 2009. Traditional investment advice is a bit like trying to prevent teenage pregnancies by asking teenagers to abstain—it’s not bad advice, but it’s unrealistic. Why not manage the risk of an individual’s portfolio more actively so as to reduce the chances of freaking out?

Finance has developed a bad reputation in the popular press, particularly in the aftermath of the recent financial crisis. Does the Adaptive Markets Hypothesis have anything to say about this and how things can be improved?

AL: Absolutely. At the heart of all bad behavior, regardless of the industry or context, is human nature. Humans are the Curious George of the animal kingdom, but there’s no “man in the yellow hat” to bail us out when we get into trouble. Homo sapiens has evolved in some remarkable ways and we’re capable of extraordinary things, both good and bad. The same social and cultural forces that give rise to wonderful organizations like the Peace Corps, the Red Cross, and Doctors without Borders can sometimes lead to much darker and destructive organizations. The only way for us to deal more effectively with the negative aspects of society is to acknowledge this dual nature of human behavior. Chapter 11 of Adaptive Markets, titled “Fixing Finance,” is devoted entirely to this objective. We have to be careful not to throw out the baby with the bathwater—the financial system definitely can be improved, but we shouldn’t vilify this critically important industry because of a few bad actors.

What are some specific proposals for how to fix finance?

AL: Well, before we can fix finance, we need to understand where financial crises come from, and the Adaptive Markets Hypothesis has a clear answer: crises are the product of human behavior coupled with free enterprise. If you can eliminate one or both of these two components, you can eliminate financial crises. Otherwise, financial crises are an avoidable fact of modern life. Human misbehavior is a force of Nature, not unlike hurricanes, flash floods, or earthquakes, and it’s not possible to legislate away these natural disasters. But this doesn’t mean we can do anything about it—we may not be able to prevent hurricanes from occurring, but we can do a great deal to prepare for them and reduce the damage they do. We can do a lot to prepare for financial crises and reduce the damage they do to those individuals and institutions least able to withstand their devastating consequences. This perspective is important because it goes against the traditional narrative that financial crises are caused by a few greedy unscrupulous financiers and once we put them in jail, we’ve taken care of the problem. The Adaptive Markets perspective suggests something different: the problem is us. Specific proposals for dealing with crises include: using new technologies in data science to measure economic activity and construct early warning indicators of impending crises; studying crises systematically like the way the National Transportation Safety Board studies airplane crashes so we know how to make the financial system safer; creating adaptive regulations that change with the environment, becoming more restrictive during booms and less restrictive during busts; and systematically measuring individual behavior and corporate culture quantitatively so we can engage in “behavioral risk management.”

Now that you’ve written this book, where do you see your research going from here?

AL: Well, this is still early days for the Adaptive Markets Hypothesis. There’s so much left to be done in exploring the implications of the theory and testing the implications empirically and experimentally whenever possible. The Efficient Markets Hypothesis took decades and hundreds of academic studies to get established, and the same will be true of this one. One of my goals in writing this book is to motivate my academic and industry colleagues to start this vetting process. In the same way that Darwin’s theory of evolution had to be tested and challenged from many different perspectives, the Adaptive Markets Hypothesis has to go through the gauntlet of academic scrutiny. One important implication of the Adaptive Markets perspective is that we need to change the way we collect data and test theories in financial economics. For example, traditional tests of financial theories involve collecting stock market prices and analyzing the statistical properties of their risks and returns. Contrast this approach with how an ecologist would study a newly discovered tropical island in an effort to preserve it. He would begin by first cataloguing the flora and fauna, identifying the key species, and measuring their biomasses and behaviors. Next, he would determine the food chain, environmental threats, and predator/prey relationships, and then turn to population dynamics in the context of the changing environment. Ultimately, such a process would lead to a much deeper understanding of the entire ecosystem, allowing ecologists to determine the best way to ensure the long-term health and sustainability of that island. Imagine doing the same thing with the financial industry. We would begin by cataloguing the different types of financial institutions and investors, measuring their financial biomass, and identifying key species—banks, hedge funds, pension funds, retail investors, regulators, etc.—and their behaviors. Then we would determine the various types of business relationships and interdependencies among these species, which are critical for mapping the population dynamics of this financial ecosystem. This approach seems sensible enough, but it’s not yet being done today (except by my collaborators and me!).

How do you continue to evolve your own thinking? What do you do?

AL: Someone very wise once said that the beginning of wisdom is humility, and I’m convinced that this is how we make progress as a civilization. Once we’re convinced that we have all the answers, we stop asking new questions and learning. So I’m continually looking for new ways to understand financial market behavior, and constantly humbled by how little I know compared to how much we have yet to discover. In this respect, I guess I’m an intellectual opportunist—I don’t care where an idea comes from or what academic discipline it belongs to; if it gives me new insight into an existing problem, I’ll use it and build on it. I’m currently working on several applications of the Adaptive Markets Hypothesis to investments, risk management, and financial regulation, and also hoping to test the theory in the context of individual and institutional investment decisions. The initial results are quite promising and show that financial industry participants adapt much more quickly than we thought. These results point to several important unintended consequences that have clear implications for how we should regulate the industry so as to reduce the chances of another financial crisis.

Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of LoManagement and director of the MIT Laboratory for Financial Engineering. He is the author of Hedge Funds and Adaptive Markets: Financial Evolution at the Speed of Thought. He is also the founder of AlphaSimplex Group, a quantitative investment management company based in Cambridge, Massachusetts.

Joel Brockner: Why Bosses Can Be Dr. Jekyll and Mr. Hyde

It is unnerving when people in authority positions behave inconsistently, especially when it comes to matters of morality. We call such people “Jekyll and Hyde characters,” based on Robert Louis Stevenson’s novella in which the same person behaved very morally in some situations and very immorally in others. Whereas the actual title of Stevenson’s work was the Strange Case of Dr. Jekyll and Mr. Hyde, recent research suggests that Jekyll and Hyde bosses may not be so unusual. In fact, behaving morally like Dr. Jekyll may cause bosses to subsequently behave immorally like Mr. Hyde.

Researchers at Michigan State University (Szu Han Lin, Jingjing Ma, and Russell Johnson) asked employees to describe the behavior of their bosses from one day to the next. Bosses who behaved more ethically on the first day were more likely to behave abusively towards their subordinates the next day. For instance, the more that bosses on the first day did things like: 1) define success not just by results but also by the way that they are obtained, 2) set an example of how to do things the right way in terms of ethics, or 3) listen to what their employees had to say, the more likely they were on the next day to ridicule employees, to give employees the silent treatment, or to talk badly about employees behind their back. Does being in a position of authority predispose people to be hypocrites?

Not necessarily. Lin, Ma, and Johnson found two reasons why ethical leader behavior can, as they put it, “break bad.” One is moral licensing, which is based on the idea that people want to think of themselves and their behavior as ethical or moral. Having behaved ethically, people are somewhat paradoxically free to behave less ethically, either because their prior behavior gave them moral credits in their psychological ledgers or because it proved them to be fine, upstanding citizens.

A second explanation is based on Roy Baumeister’s notion of ego depletion, which assumes that people have a limited amount of self-control resources. Ego depletion refers to how people exerting self-control in one situation are less able to do so in a subsequent situation. Ego depletion helps to explain, for instance, why employees tend to make more ethical decisions earlier rather than later in the day. Throughout the day we are called upon to behave in ways that require self-control, such as not yelling at the driver who cut us off on the way to work, not having that second helping of delicious dessert at lunch, and not expressing negative emotions we may be feeling about bosses or co-workers who don’t seem to be behaving appropriately, in our view. Because we have fewer self-control resources later in the day, we are more susceptible to succumb to the temptation to behave unethically. In like fashion, bosses who behave ethically on one day (like Dr. Jekyll) may feel ego depleted from having exerted self-control, making them more prone to behave abusively towards their subordinates the next day (like Mr. Hyde).

Distinguishing between moral licensing and ego depletion is important, both conceptually and practically. At the conceptual level, a key difference between the two is whether the self is playing the role of object or subject. When people take themselves as the object of attention they want to see themselves and their behavior positively, for example, as ethical. As object (which William James called the me-self), self-processes consist of reflecting and evaluating. When operating as subject, the self engages in regulatory activity, in which people align their behavior with meaningful standards coming from within or from external sources; James called this the I-self. Moral licensing is a self-as-object process, in which people want to see themselves in certain positive ways (e.g., ethical), so that when they behave ethically they are free, at least temporarily, to behave in not so ethical ways. Ego depletion is a self-as-subject process, in which having exerted self-control in the service of regulation makes people, at least temporarily, less capable of doing so.

The founding father of social psychology, Kurt Lewin, famously proclaimed that, “There is nothing so practical as a good theory.” Accordingly, the distinction between moral licensing and ego depletion lends insight into the applied question of how to mitigate the tendency for ethical leader behavior to break bad. The moral licensing explanation suggests that one way to go is to make it more difficult for bosses to make self-attributions for their ethical behavior. For instance, suppose that an organization had very strong norms for its authorities to behave ethically. When authorities in such an organization behave ethically, they may attribute their behavior to the situation (strong organizational norms) rather than to themselves. In this example authorities are behaving morally but are not licensing themselves to behave abusively.

The ego depletion explanation suggests other ways to weaken the tendency for bosses’ ethical behavior to morph into abusiveness. For instance, much like giving exercised muscles a chance to rest and recover, ensuring that bosses are not constantly in the mode of exerting self-control may allow for their self-regulatory resources to be replenished. It also has been shown that people’s beliefs about how ego depleted they are influences their tendency to exert self-control, over and above how ego depleted they actually are. In a research study appropriately titled, “Ego depletion—is it all in your head?,” Veronika Job, Carol Dweck, and Gregory Walton found that people who believed they were less ego depleted after engaging in self-control were more likely to exert self-control in a subsequent activity. People differ in their beliefs about the consequences of exercising self-control. For some, having to exert self-control is thought to be de-energizing whereas for others it is not believed to be de-energizing. Bosses who believe that exerting self-control is not de-energizing may be less prone to behave abusively after exerting the self-control needed to behave ethically.

Whereas we have focused on how Dr. Jekyll can awaken Mr. Hyde, it also is entirely possible for Mr. Hyde to bring Dr. Jekyll to life. For instance, after behaving abusively bosses may want to make up for their bad feelings about themselves by behaving ethically. In any event, the case of Dr. Jekyll and Mr. Hyde may not be so strange after all. We should not be surprised by inconsistency in our bosses’ moral behavior, once we consider how taking the high road may cause them to take the low road, and vice versa.

BrocknerJoel Brockner is the Phillip Hettleman Professor of Business at Columbia Business School. He is the author of The Process Matters: Engaging and Equipping People for Success.

This article was originally published on Psychology Today.

Walter Scheidel on what really reduces inequality: Violent shocks

ScheidelWhat really reduces economic inequality? According to Walter Scheidel, the surprising answer is something nobody would wish for: mass violence and catastrophe. Tracing the global history of inequality from the Stone Age to today, Scheidel shows that inequality never dies peacefully—it consistently declines when carnage and disaster strike and increases when peace and stability return. The Great Leveler is the first book to chart the crucial role of violent shocks in reducing inequality over the full sweep of human history around the world. Recently, Scheidel took the time to answer some questions about his startling conclusions:

What is the great leveler?

Violence is the great leveler, expended in massive shocks that upend the established order and flatten the distribution of income and wealth. There are four major types of shocks, which I call the Four Horsemen. That’s a fitting image because they were just as terrible as the bringers of doom in the Revelation of John. The first of them is mass mobilization warfare, which reached its heyday during the two World Wars when enormous physical destruction, confiscatory taxation, aggressive government intervention in the economy, inflation, and the disruption of global flows of trade and capital wiped out elite wealth and redistributed resources on a massive scale. These struggles also served as a uniquely powerful catalyst for equalizing political reform, promoting extensions of the franchise, union membership, and the welfare state. The second is transformative revolution, which was also primarily a phenomenon of the twentieth century, when communists expropriated, redistributed and then collectivized, in the process matching the World Wars in terms of body count and human misery. The collapse of states is the third one, not uncommon in the more distant past: everyone suffered when law and order unraveled but the rich simply had more to lose. Plague rounds off this ghastly quartet. On a number of occasions, most famously during the Black Death of the Late Middle Ages, epidemics carried off so many people that labor became scare and real incomes of workers rose while the land and capital holdings of the upper class lost value.

Your book covers thousands of years. Surely things must have changed over time?

Of course they have, but less than you might think. It was the sources of inequality that experienced the biggest changes. The shift to farming and herding after the last Ice Age let our ancestors create material assets that could be passed on to future generations, allowing some families to pull away from the rest. Later, as states and empires appeared and grew in size and power, elites filled their pockets with profits from public office, corruption, coercion and plunder. While this continues to be common practice in some parts of the world, in the West gains from commerce and enterprise have gradually replaced those more archaic form of enrichment. But even as these changes unfolded over the long run of history, violent shocks remained the most potent mechanisms of leveling.

But what about the postwar decades? Didn’t the economy grow and the middle class prosper at the same time as inequality declined?

That’s true, and that’s why many people in America and Europe look back to this period as a time of great progress and welfare. Current ideas of “making America great again” owe a lot to this happy convergence of affluence and equality, and reflect the understandable desire to somehow bring it back. But we must not forget that it was the carnage and the perils of the Second World War that undergirded the entire process. After the New Deal had ushered in progressive policies, it was the war effort that gave rise to the many invasive regulations and taxes that ensured that future gains would be more equitably distributed. This benign fallout from the war faded over time until a new round of liberalization, competitive globalization and technological change allowed inequality to soar once again. Since the 1980s, the economy has continued to expand but a growing share of the pie has been captured by the much-quoted “one percent.”

That’s a sobering perspective. Aren’t there any other factors that can combat inequality and don’t involve bloodshed and misery?

Absolutely. But they often fall short one way or another. Economic crises may hurt the rich for a few years but don’t normally have serious long-term consequences. By reducing inequality and prompting progressive policies, the Great Depression in the U.S. was a bit of outlier compared to the rest of the world. Perhaps surprisingly, political democracy by itself does not ensure a more equal distribution of income and wealth. Nor does economic growth as such. Education undeniably plays an important role by matching skills with demand for labor: most recently, it helped lower the massive disparities that have long weighed down many Latin American countries. Even so, the historical record shows that all of these factors were at their most effective in the context or aftermath of major violent shocks, such as the World Wars. Successful land reform, which is of critical importance in agrarian societies, has likewise often been the product of war and revolution or the fear of violent conflict.

This doesn’t raise much hope for the future. What are the chances that we will be able to return to a fairer distribution of income and wealth?

That’s a good question, although few people will like my answer. The traditional mechanisms of major leveling, the Four Horsemen, currently lie dormant: technological progress has made future mass warfare less likely, there are currently no revolutions on the horizon, states are much more stable than they used to be, and genetics will help us ward off novel epidemics. That’s a good thing – nobody in their right mind should yearn for death and destruction just to create greater equality. But similarly powerful peaceful means of leveling have yet to be found. And to make matters worse, a number of ongoing developments may drive up inequality even further: the aging of Western societies, immigration’s pressure on social solidarity and redistributive policies, and the prospect of ever more sophisticated automation and genetic and cybernetic enhancement of the human body. Barring major disruptions or an entirely new politics of equality, we may well be poised to enter a long period of polarization, another Gilded Age that separates the haves from the have-nots.

ScheidelWalter Scheidel is the Dickason Professor in the Humanities, Professor of Classics and History, and a Kennedy-Grossman Fellow in Human Biology at Stanford University. The author or editor of sixteen previous books, he has published widely on premodern social and economic history, demography, and comparative history. He is the author of The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century.

Edward Balleisen on the long history of fraud in America

BalleisenDuplicitous business dealings and scandal may seem like manifestations of contemporary America gone awry, but fraud has been a key feature of American business since its beginnings. The United States has always proved an inviting home for boosters, sharp dealers, and outright swindlers. Worship of entrepreneurial freedom has complicated the task of distinguishing aggressive salesmanship from unacceptable deceit, especially on the frontiers of innovation. At the same time, competitive pressures have often nudged respectable firms to embrace deception. In Fraud: An American History from Barnum to Madoff, Edward Balleisen traces the history of fraud in America—and the evolving efforts to combat it. Recently, he took the time to answer some questions about his book.

Can you explain what brought you to write this book?

EB: For more than two decades, I have been fascinated by the role of trust in modern American capitalism and the challenges posed by businesses that break their promises. My first book, Navigating Failure: Bankruptcy and Commercial Society in Antebellum America, addressed this question by examining institutional responses to insolvency in the mid-nineteenth-century. This book widens my angle of vision, considering the problem of intentional deceit in the United States across a full two centuries.

In part, my research was motivated by the dramatic American fraud scandals of the late 1990s and early 2000s, which demonstrated how badly duplicitous business practices could hurt investors, consumers, and general confidence in capitalism. I wanted to understand how American society had developed strategies to constrain such behavior, and why they had increasingly proved unequal to the task since the 1970s.

In part, I was gripped by all the compelling stories suggested by historical episodes of fraud, which often involve charismatic business-owners, and often raise complex questions about how to distinguish enthusiastic exaggeration from unscrupulous misrepresentation.

In part, I wanted to tackle the challenges of reconstructing a history over the longer term. Many of the best historians during the last generation have turned to microhistory – detailed studies of specific events or moments. But there is also an important place for macro-history that traces continuity and change over several generations.

In addition, my research was shaped by increasingly heated debates about the costs and benefits of governmental regulation, the extent to which the social legitimacy of market economies rest on regulatory foundations, and the best ways to structure regulatory policy. The history of American anti-fraud policy offers compelling evidence about these issues, and shows that smart government can achieve important policy goals.

What are the basic types of fraud?

EB: One important distinction involves the targets of intentional economic deceit. Sometimes individual consumers defraud businesses, as when they lie on applications for credit or life insurance. Sometimes taxpayers defraud governments, by hiding income. Sometimes employees defraud employers, by misappropriating funds, which sociologists call “occupational fraud.” I focus mostly on deceit committed by firms against their counterparties (other businesses, consumers, investors, the government), or “organizational fraud.”

Then there are the major techniques of deception by businesses. Within the realm of consumer fraud, most misrepresentations take the form of a bait and switch – making big promises about goods or services, but then delivering something of lesser or even no quality.

Investment fraud can take this form as well. But it also may depend on market manipulations – spreading rumors, engaging in sham trades, or falsifying corporate financial reports in order to influence price movements, and so the willingness of investors to buy or sell; or taking advantage of inside information to trade ahead of market reactions to that news.

One crucial type of corporate fraud involves managerial looting. That is, executives engage in self-dealing. They give themselves outsized compensation despite financial difficulties, direct corporate resources to outside firms that they control in order to skim off profits, or even drive their firms into bankruptcy, and then take advantage of inside information to buy up assets on the cheap.

Why does business fraud occur?

EB: Modern economic life presents consumers, investors, and businesses with never-ending challenges of assessing information. What is the quality of goods and services on offer, some of which may depend on newfangled technologies or complex financial arrangements? How should we distinguish good investment opportunities from poor ones?

In many situations, sellers and buyers do not possess the same access to evidence about such issues. Economists refer to this state of affairs as “information asymmetry.” Then there is the problem of information overload, which leads many economic actors to rely on mental short-cuts – rules of thumb about the sorts of businesses or offers that they can trust. Almost all deceptive firms seek to look and sound like successful enterprises, taking advantage of the tendency of consumers and investors to rely on such rules of thumb. Some of the most sophisticated financial scams even try to build confidence by warning investors about other frauds.

A number of common psychological tendencies leave most people susceptible to economic misrepresentations at least some of the time. Often we can be taken in by strategies of “framing” – the promise of a big discount from an inflated base price may entice us to get out our wallets, even though the actual price is not much of a bargain. Or a high-pressure stock promoter may convince us to invest by convincing us that we have to avoid the regret that will dog us if we hold back and then lose out on massive gains.

How has government policy toward business fraud changed since the early nineteenth century?

EB: In the nineteenth century, Anglo-American law tended to err on the side of leniency toward self-promotion by businesses. In most situations, the key legal standard was caveat emptor, or let the buyer beware. For the judges and legislators who embraced this way of thinking, markets worked best when consumers and investors knew that they had to look out for themselves. As a result, they adopted legal rules that often made it difficult for economic actors to substantiate allegations of illegal deceit.

For more than a century after the American Civil War, however, there was a strong trend to make anti-fraud policies less forgiving of companies that shade the truth in their business dealings. As industrialization and the emergence of complex national markets produced wider information asymmetries, economic deceit became a bigger problem. The private sector responded through new types of businesses (accounting services, credit reporting) and self-regulatory bodies to certify trustworthiness. But from the late nineteenth century into the 1970s, policy-makers periodically enacted anti-fraud regulations that required truthful disclosures from businesses, and that made it easier for investors and consumers to receive relief when they were taken for a ride.

More recently, the conservative turn in American politics since the 1970s led to significant policy reversals. Convinced that markets would police fraudulent businesses by damaging their reputations, elected officials cut back on budgets for anti-fraud enforcement, and rejected the extension of anti-fraud regulations to new financial markets like debt securitization.

Since the Global Financial Crisis of 2007-08, which was triggered in part by widespread duplicity in the mortgage markets, Americans have again seen economic deceit as a worrisome threat to confidence in capitalist institutions. That concern has prompted the adoption of some important anti-fraud policies, like the creation of the Consumer Financial Protection Bureau. But it remains unclear whether we have an entered a new era of greater faith in government to be able to constrain the most harmful forms of business fraud.

Many journalists and pundits have characterized the last several decades as generating epidemics of business fraud. What if anything is distinctive about the incidence of business fraud since the 1970s?

EB: Fraud episodes have occurred in every era of American history. During the nineteenth century, railroad contracting frauds abounded, as did duplicity related to land companies and patent medicine advertising. Deception in the marketing of mining stocks became so common that a prevalent joke defined “mine” as “a hole in the ground with a liar at the top.” From the 1850s through the 1920s, Wall Street was notorious for the ruthless manner in which dodgy operators fleeced unsuspecting investors.

Business frauds hardly disappeared in mid-twentieth-century America. Indeed, bait and switch marketing existed in every urban retailing sector, and especially in poor urban neighborhoods. Within the world of investing, scams continued to target new-fangled industries, such as uranium mines and electronics. As Americans moved to the suburbs, fraudulent pitchmen followed right behind, with duplicitous franchising schemes and shoddy home improvement projects.

The last forty years have also produced a regular stream of major fraud scandals, including the Savings & Loan frauds of the 1980s and early 1990s, contracting frauds in military procurement and healthcare reimbursement during the 1980s and 1990s, corporate accounting scandals in the late 1990s and early 2000s, and frauds associated with the collapse of the mortgage market in 2007-2008.

Unlike in the period from the 1930s through the 1970s, however, business fraud during the more recent four decades have attained a different scale and scope. The costs of the worst episodes have reached into the billions of dollars (an order of magnitude greater than their counterparts in the mid-twentieth century, taking account of inflation and the overall growth in the economy), and have far more frequently involved leading corporations.

Why is business fraud so hard to stamp out through government policy?

EB: One big challenge is presented by the task of defining fraud in legal terms. In ordinary language, people often refer to any rip-off as a “fraud.” But how should the law distinguish between enthusiastic exaggerations, so common among entrepreneurs who just know that their business is offering the best thing ever, and unacceptable lies? Drawing that line has never been easy, especially if one wants to give some leeway to new firms seeking to gain a hearing through initial promotions.

Then there are several enduring obstacles to enforcement of American anti-fraud regulations. Often specific instances of business fraud impose relatively small harms on individuals, even if overall losses may be great. That fact, along with embarrassment at having been duped, has historically led many American victims of fraud to remain “silent suckers.” Proving that misrepresentations were intentional is often difficult; as is explaining the nature of deception to juries in complex cases of financial fraud.

The most effective modes of anti-fraud regulation often have been administrative in character. They either require truthful disclosure of crucial information to consumers and investors, at the right time and incomprehensible language, or they cut off access to the marketplace to fraudulent businesses. Postal fraud orders constitute one example of the latter sort of policy. When the post office determines that a business has engaged in fraudulent practices, it can deny it the use of the mails, a very effective means of policing mail-order firms. Such draconian steps, however, have always raised questions about fairness and often lead to the adoption of procedural safeguards that can blunt their impact.

How does this book help us better understand on contemporary frauds, such as the Madoff pyramid scheme or the Volkswagen emissions scandal?  

EB: One key insight is that so long as economic transactions depend on trust, and so long as there are asymmetries of information between economic counterparties, there will be significant incentives to cheat. Some economists and legal thinkers argue that the best counter to these incentives are reputational counterweights. Established firms, on this view, will not take actions that threaten their goodwill; newer enterprises will focus on earning the trust of creditors, suppliers, and customers. And heavy-handed efforts to police deceptive practices remove the incentive for economic actors to exercise due diligence, while raising barriers to entry, and so limiting the scope for new commercial ideas. This way of thinking shares much in common with the philosophy of caveat emptor that structured most American markets in the nineteenth-century.

But as instances like the Madoff investment frauds and Volkswagen’s reliance on deceptive emissions overrides suggest, reputational considerations have significant limits. Even firms with sterling reputations are susceptible to fraud. This is especially the case when regulatory supports, and wider social norms against commercial dishonesty, are weak.

The title of this book is Fraud: An American History from Barnum to Madoff. What do you see as uniquely American about this history of fraud?  

EB: The basic psychological patterns of economic deception have not changed much in the United States. Indeed, these patterns mirror experimental findings regarding vulnerabilities that appear to be common across societies. Thus I would be skeptical that the tactics of an investment “pump and dump” or marketing “bait and switch” would look very different in 1920s France or the Japan of the early 21st century than in the U.S. at those times.

That said, dimensions of American culture have created welcome ground for fraudulent schemes and schemers. American policy-makers have tended to accord great respect to entrepreneurs, which helps to explain the adoption of a legal baseline of caveat emptor in the nineteenth century, and the partial return to that baseline in the last quarter of the twentieth-century.

The growth of the antifraud state, however, likely narrowed the differences between American policies and those in other industrialized countries. One hope of mine for this book is that it prompts more historical analysis of antifraud regulation elsewhere – in continental Europe, Latin America, Africa, and Asia. We need more detailed histories in other societies before we can draw firmer comparative conclusions.

What do you see as the most important implications of this book for policy-makers charged with furthering consumer or investor protection?

EB: Business fraud is a truly complex regulatory problem. No modern society can hope to eliminate it without adopting such restrictive rules as to strangle economic activity. But if governments rely too heavily on the market forces associated with reputation, business fraud can become sufficiently common and sufficiently costly to threaten public confidence in capitalist institutions. As a result, policy-makers would do well to focus on strategies of fraud containment.

That approach calls for:

• well-designed campaigns of public education for consumers and investors;
• empowering consumers and investors through contractual defaults, like cooling off periods that allow consumers to back out of purchases;
• cultivating social norms that stigmatize businesses that take the deceptive road;
• building regulatory networks to share information across agencies and levels of government, and between government bodies and the large number of antifraud NGOs; and
• a determination to shut down the most unscrupulous firms, not only to curb their activities, but also to persuade everyone that the state is serious about combating fraud.

Edward Balleisen talks about his new book:

Edward J. Balleisen is associate professor of history and public policy and vice provost for Interdisciplinary Studies at Duke University. He is the author of Navigating Failure: Bankruptcy and Commercial Society in Antebellum America and Fraud: An American History from Barnum to Madoff. He lives in Durham, North Carolina.

Kenneth Rogoff: Australia contemplates moving to a less cash society

RogoffToday in our blog series by Kenneth Rogoff, author of The Curse of Cash, Rogoff discusses Australia’s exploration of a less-cash society. Read other posts in the series here.

Recently, the Australian government stirred up a great deal of controversy by announcing the formation of task force to study the role of cash in the underground or “black” economy. There is no suggestion of an impetuous overnight change a la India, but rather a slow deliberative process. (For a recent review of The Curse of Cash with a special focus on the Indian context, see Businessline). Among other ideas, the task force is going to consider phasing out the Australian $100 bill (and presumably eventually the $50 in due time). It will also contemplate restrictions on the maximum size of cash purchases (as France, Italy, Spain, Greece and other European countries have done), and to wire cash registers to transmit sales information directly to the Treasury, as countries such as Sweden have done. According to the Minister for Revenue and Financial Services, Kelly O’Dwyer, the taskforce will have the full cooperation of the Federal police, immigration authorities, the Reserve Bank of Australia and financial regulators.

Of course, the issues with paper currency and how to mitigate them are the main topic of The Curse of Cash, which also provides historical context, data and institutional detail an an economic analysis of the issues. Australia is in many ways a very typical advanced economy when it comes to cash, with huge amounts of cash outstanding and unaccounted for, and mostly in the form of very large denomination notes. Roughly 93% of the Australian paper currency supply is in the form of $100 and $50 dollar bills (versus, say, 85% for the United States, and just over 90% for bills over 50 euro in the Euro area).

(Updated from The Curse of Cash, which goes through end 2015, when large notes constituted 92% of the money supply; all the data and figures for the book are posted here).

With 328 million $100s in circulation and 643 million $50s, there are roughly 14 $100 dollar bills for every man, woman and child in Australia, and roughly 27 $50s. As elsewhere, only a small fraction of these are accounted for.

Overall, the value of cash in circulation (70 billion Australian dollars) is a little over 4% of GDP, which puts Australia in the mainstream of advanced economies, about on par with the UK and Canada, and similar to the United States if USD held abroad are excluded. (See Figure 3.4 in The Curse of Cash).   

As in the US, cash is widely used for small transactions in Australia, accounting for 70% of transactions under $20 according to an April 2016 report by the Australian National Audit office in April 2016. But as in the United States, the importance of cash drops sharply for larger transactions – and that is even considering money washing back from the black economy into retail transactions. (See Figure 4.2 in The Curse of Cash).

Predictably, the Australian government announcement met with the usual tirades that equate getting rid of the large denomination notes with going cashless. This is polemic nonsense, readers of my book will know; I have also discussed the fundamental distinction in my blogs. Any legal fully tax-compliant transaction that ordinary citizens want to engage in can be executed easily enough with $20 bills (or even $10 bills), up to very large amounts. And smaller bills are also more than sufficient to satisfy ordinary people’s needs for privacy, the loss of big bills is a far greater detriment to those engaged in tax evasion and crime. Another strand of nonsense is that there must be better ways to increase tax compliance, such as lowering tax rates. (We can recall this from James Grant’s broadside rant in the Wall Street Journal.) Of course it would be good to improve the tax system, but tax evasion is always going to be an issue, and so will enforcement. And to the extent the government can collect a larger share of what it is owed from people who now avoid taxes by clever use of cash, then rates can be lowered for everyone else.

It is also nonsense to say that criminals and tax evaders will not feel the bite of a less cash society, and that they will effortlessly turn to other vehicles such as Bitcoin. There are good reasons why cash is king and why international law enforcement authorities find that cash is used somewhere along the line in almost every major criminal enterprise. Other vehicles simply cannot replicate its universality, convenience and liquidity. (Again, all this is discussed at length in the The Curse of Cash).

Not surprisingly, there has been pushback from the Reserve Bank of Australia, which argues that 5% of the cash banked by retailers is in 100s. This, of course, hardly matches up to the 45% of the cash supply that is 100s and more importantly, does not take into account that money from the black economy is routinely spent at retail stores. Many central banks are understandably reticent that a fall in the demand for cash will hurt their “seigniorage profits” from printing cash. The book discusses different conceptual approaches to measuring seigniorage. Perhaps the simplest measure is simply net new currency printed each year as a share of GDP). By this metric the Reserve Bank of Australia earned an average of .25% of GDP annually on average from 2006-2015, a very significant sum of money (see chapter 6.) But, as the book argues, the consolidated government (including the central bank) are likely losing even more through cash-facilitated tax evasion, and that does not even count the costs to the public of cash-facilitated crime.

The Australian authorities have noted that under-reporting of cash income has also distorted the welfare system (The Curse of Cash discusses this issue including evidence on Canada). Indeed, former senior Australian Reserve Bank official Peter Maier has argued that large denomination notes are widely hoarded by pensioners who aim to evade Australia’s mean-tested pension system. There are some tricky issues here having to do with privacy and tax fairness, but all in all, getting rid of big bills mainly hits those engaged in wholesale tax evasion and crime, not the poor. The Curse of Cash suggests low-cost approaches to financial inclusion to ensure that low-income families benefit beyond just reduction in crime.

Australia’s gradual and careful approach to dealing with cash is nothing like India’s radical policy, which aims at the same problems, but has created massive collateral damage. For a discussion of India, see here, here and here. The Australian cash commission’s report is due in October 2017; it is a welcome step. Given that Australia has been a huge innovator in currency (the Reserve Bank of Australia commission the first modern polymer notes that the UK and Canada have now adopted), it is encouraging that Australia is still willing to take the lead in the move to a less cash society.

Kenneth S. Rogoff, the Thomas D. Cabot Professor of Public Policy at Harvard University and former chief economist of the International Monetary Fund, is the coauthor of the New York Times bestseller This Time Is Different: Eight Centuries of Financial Folly (Princeton). He appears frequently in the national media and writes a monthly newspaper column that is syndicated in more than fifty countries. He lives in Cambridge, Massachusetts.

Find Kenneth Rogoff on Twitter: @krogoff