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

Doom vs. Boom: Robert Gordon and Joel Mokyr on the future of American growth

From Northwestern Now:

It has been called the ‘clash of titans.’ Two of the biggest names in economics research–Bob Gordon and Joel Mokyr – have been battling it out in the press for years with fiery arguments in the Wall Street Journal and the New York Times, plus debates in countries all over the world, including the latest at the Chicago Council on Global Affairs.

Robert Gordon, author of The Rise and Fall of American Growth, and Joel Mokyr, author of A Culture of Growth, go head to head in their latest debate on the future of economic growth in the United States. You can listen to it via the Northwestern Now podcast, or read the full transcript.

 

Gordon

 

Mokyr

Joel Mokyr: How the modern economy was born

MokyrBefore 1800, the majority of people lived on the verge of subsistence. In A Culture of Growth: The Origins of the Modern Economy, esteemed historian Joel Mokyr explains why in the industrialized world such a standard of living has grown increasingly uncommon. Mokyr offers a groundbreaking view on a culture of growth specific to early modern Europe, showing how the European Enlightenment laid the foundations for the scientific advances and pioneering inventions that would instigate explosive technological and economic development. Recently, Mokyr took some time to answer questions about the book.


How would you sum up the book’s main points?

JM: Before 1800 the overwhelming majority of humankind was poor; today in the industrialized world, almost nobody lives at the verge of subsistence, and a majority of people in the world enjoy living standards that would have been unimaginable a few centuries ago. My book asks how and why that happened. The question of the Great Enlightenment is central to economic history; a Nobel prize winning economist, Robert Lucas, once wrote that once we start thinking about it, it is hard to think of anything else.

Do we know how and where this started? 

JM: Yes, it started in Western Europe (primarily in Britain) in the last third of the eighteenth century through a set of technological innovations we now call the Industrial Revolution. From there it spread to the four corners of the world, although the success rate varied from place to place, and often the new techniques had to be adapted to local circumstances.

How is this book different from other work looking at this event? 

JM: The literature looking at the question of why this happened has advanced three types of explanations: geographical (looking at resources and natural endowments), political-institutional (focusing on the State and economic policies), or purely economic, through prices and incomes. My book examines culture: what did people believe, value, and how did they learn to understand natural phenomena and regularities they could harness to their material improvement.

Whose culture mattered most here? 

JM: Good question! Technological progress and the growth of modern science were driven first and foremost by a small educated elite of literate people who had been trained in medicine, mathematics and what they called “natural philosophy.” The culture of the large majority of people, who were as yet uneducated and mostly illiterate, mattered less in the early stages, but became increasingly important at a later stage when mass education became the norm.

So what was it about these intellectuals that mattered most? 

JM: In my earlier work, especially my The Enlightened Economy (2009), I pointed to what I called “the Industrial Enlightenment” as the central change that prepared the ground for modern economic growth. In the new book, I explain the origins of the Industrial Enlightenment. At some point, say around 1700, the consensus of intellectuals in Europe had become that material progress (what we were later to call “economic growth”) was not only desirable but possible, and that increasing what they called “useful knowledge” (science and technology) was the way to bring it about. These intellectuals then carried out that program through continuous advances in science that eventually found a myriad of economic applications.

How and why did this change happen? 

JM: That is the main question this book is focusing on and tries to answer. It describes and analyzes the cultural changes in the decades between Columbus and Newton, during what is sometimes known as “early modern Europe.” It was an age of tremendous cultural changes, above all of course the Reformation and the Scientific Revolution. Equally important was the emergence of what is known as “the Baconian Program,” in which Francis Bacon and his followers formulated the principles of what later became the Industrial Enlightenment. The success of these thinkers to persuade others of the validity of their notions of progress and the importance of a research agenda that reflected real economic needs is at the heart of the story of how the Industrial Enlightenment emerged.

So why did this take place in this period and in Europe, and not somewhere else? 

JM: Europe in this age enjoyed an unusual structure that allowed new and fresh ideas to flourish as never before. On the one hand, it was politically and religiously fragmented into units that fiercely competed with one another. This created a competitive market both for and among intellectuals that stimulated intellectual innovation. It was a market for ideas that worked well and in it the Baconian Program was an idea that succeeded, in part because it was attractive to many actors, but also because it was marketed effectively by cultural entrepreneurs. At the same time, political fragmentation coexisted with a unified and transnational institution (known at the time as the Republic of Letters) that connected European intellectuals through networks of correspondence and publications and created a pan-European competitive market in which new ideas circulated all over the Continent. In this sense, early modern Europe had the “best of all possible worlds” in having all the advantages of diversity and fragmentation and yet have a unified intellectual community.

Of all the new ideas, which ones were the most important? 

JM: Many new ideas played a role in the intellectual transformations that eventually led to the waves of technological progress we associate with modern growth. One of the most important was the decline in the blind veneration of ancient learning that was the hallmark of many other cultures. Shaking off the paralyzing grip of past learning is one of the central developments that counted in the cultural evolution in this period. The “classical canon” of Ptolemy and Aristotle was overthrown by rebels such as Copernicus and Galileo, and over time the intellectuals of this age became more assertive in their belief that they could outdo classical learning and that many of the conventional beliefs that had ruled the world of intellectuals in astronomy, medicine, and other fields were demonstrably wrong. Evidence and logic replaced ancient authority.

Was the success of the new ideas a foregone conclusion? 

JM: Not at all: there was fierce resistance to intellectual innovation by a variety of conservative powers, both religious and political. Many of the most original and creative people were persecuted. But in the end resistance failed, in large part because both people and books — and hence ideas — could move around in Europe and move to more liberal areas where their reception was more welcomed.

Could an Industrial Enlightenment not have happened elsewhere, for example in China? 

JM: The book deals at length with the intellectual development of China. In many ways, China’s economy in 1500 was as advanced and sophisticated as Europe. But in China the kind of competitive pluralism and diversity that were the hallmark of Europe were absent, and even though we see attempts to introduce more progressive thinking in China, it never succeeded to overthrow the conservative vested interests that controlled the world of intellectuals, above all the Mandarine bureaucracy. Instead of explosive growth as in Europe, Chinese science and technology stagnated.

Does the book have any implications for our own time? 

JM: By focusing on the social and economic mechanisms that stimulated and encouraged technological innovation in the past, my book points to the kind of factors that will ensure future technological creativity. First and foremost, innovation requires the correct incentives. Intellectuals on the whole do not require vast riches, but they will struggle for some measure of economic security and the opportunity to do their research in an environment of intellectual freedom in which successful innovation is respected and rewarded. Second, the freedom to innovate thrives in environments that are internationally competitive: just as much of innovation in earlier times emerged from the rivalry between England, France, Spain and the United Provinces, in the modern era the global competition between the United States, the EU, China, and so on will ensure continuous innovation. International competition and mobility ensure the intellectual freedom needed to propose new ideas. Finally, global institutions that share and distribute knowledge, as well as coordinate and govern intellectual communities of scientists and innovators across national boundaries and cultural divides, are critical for continued technological progress.

Joel Mokyr  is the Robert H. Strotz Professor of Arts and Sciences and professor of economics and history at Northwestern University, and Sackler Professor at the Eitan Berglas School of Economics at the University of Tel Aviv, Israel. He is the recipient of of the Heineken Prize for History and the International Balzan Prize for Economic History. Mokyr’s other works include The Enlightened Economy and the Gifts of Athena: Historical Origins of the Knowledge of Economy. His most recent book is a Culture of Growth: The Origins of the Modern Economy.

Kenneth Rogoff: India’s Currency Exchange and The Curse of Cash

RogoffToday in our blog series by Kenneth Rogoff, author of The Curse of Cash, Rogoff discusses the controversy over India’s currency exchange. Read other posts in the series here.

On the same day that the United States was carrying out its 2016 presidential election, India’s Prime Minister, Narendra Modi, announced on national TV that the country’s two highest-denomination notes, the 500 and 1000 rupee (worth roughly $7.50 and $15.00) would no longer be legal tender by midnight that night, and that citizens would have until the end of the year to surrender their notes for new ones. His stated aim was to fight “black money”: cash used for tax evasion, crime, terror, and corruption. It was a bold, audacious move to radically alter the mindset of an economy where less than 2% of citizens pay income tax, and where official corruption is endemic.

MOTIVATION SAME AS IN THE CURSE OF CASH

Is India following the playbook in The Curse of Cash? On motivation, yes, absolutely. A central theme of the book is that whereas advanced country citizens still use cash extensively (amounting to about 10% of the value of all transactions in the United States), the vast bulk of physical currency is held in the underground economy, fueling tax evasion and crime of all sorts. Moreover, most of this cash is held in the form of large denomination notes such as the US $100 that are increasingly unimportant in legal, tax-compliant transactions. Ninety-five percent of Americans never hold $100s, yet for every man, woman and child there are 34 of them. Paper currency is also a key driver of illegal immigration and corruption. The European Central Bank recently began phasing out the 500 euro mega-note over these concerns, partly because of the terrorist attacks in Paris.

BUT SETTING AND IMPLEMENTATION IS VASTLY DIFFERENT

On implementation, however, India’s approach is radically different, in two fundamental ways. First, I argue for a very gradual phase-out, in which citizens would have up to seven years to exchange their currency, but with the exchange made less convenient over time. This is the standard approach in currency exchanges. For example this is how the European swapped out legacy national currencies (e.g the deutschmark and the French franc) during the introduction of the physical euro fifteen years ago. India has given people 50 days, and the notes are of very limited use in the meantime. The idea of taking big notes out of circulation at short notice is hardly new, it was done in Europe after World War II for example, but as a peacetime move it is extremely radical. Back in the 1970s, James Henry suggested an idea like this for the United States (see my October 26 new blog on his early approach to the big bills problem). Here is what I say there about doing a fast swap for the United States instead of the very gradual one I recommend:

 “(A very fast) swap plan absolutely merits serious discussion, but there might be significant problems even if the government only handed out small bills for the old big bills. First, there are formidable logistical problems to doing anything quickly, since at least 40% of U.S. currency is held overseas. Moreover, there is a fine line between a snap currency exchange and a debt default, especially for a highly developed economy in peacetime. Foreign dollar holders especially would feel this way. Finally, any exchange at short notice would be extremely unfair to people who acquired their big bills completely legally but might not keep tabs on the news.

In general, a slow gradual currency swap would be far less disruptive in an advanced economy, and would leave room for dealing with unanticipated and unintended consequences. One idea, detailed in The Curse of Cash, is to allow people to exchange their expiring large bills relatively conveniently for the first few years (still subject to standard anti-money-laundering reporting requirements), then over time make it more inconvenient by accepting the big notes at ever fewer locations and with ever stronger reporting requirements.

Second, my approach eliminates large notes entirely. Instead of eliminating the large notes, India is exchanging them for new ones, and also introducing a larger, 2000-rupee note, which are also being given in exchange for the old notes.

MY PLAN IS EXPLICITLY TAILORED TO ADVANCED ECONOMIES

The idea in The Curse of Cash of eliminating large notes and not replacing them is not aimed at developing countries, where the share of people without effective access to banking is just too large. In the book I explain how a major part of any plan to phase out large notes must include a significant component for financial inclusion. In the United States, the poor do not really rely heavily on $100 bills (virtually no one in the legal economy does) and as long as smaller bills are around, the phase out of large notes should not be too much of a problem, However, the phaseout of large notes is golden opportunity to advance financial inclusion, in the first instance by giving low income individuals access to free basic debt accounts. The government could use these accounts to make transfers, which would in turn be a major cost saving measure. But in the US, only 8% of the population is unbanked. In Colombia, the number is closer to 50% and, by some accounts, it is near 90% in India. Indeed, the 500 rupee note in India is like the $10 or $20 bill in the US and is widely used by all classes, so India’s maneuver is radically different than my plan. (That said, I appreciate that the challenges are both different and greater, and the long-run potential upside also much higher.)

Indeed, developing countries share some of the same problems and the corruption and counterfeiting problem is often worse. Simply replacing old notes with new ones does have a lot of beneficial effects similar to eliminating large notes. Anyone turning in large amounts of cash still becomes very vulnerable to legal and tax authorities. Indeed that is Modi’s idea. And criminals have to worry that if the government has done this once, it can do it again, making large notes less desirable and less liquid. And replacing notes is also a good way to fight counterfeiting—as The Curse of Cash explains, it is a constant struggle for governments to stay ahead of counterfeiters, as for example in the case of the infamous North Korean $100 supernote.

Will Modi’s plan work? Despite apparent huge holes in the planning (for example, the new notes India is printing are a different size and do not fit the ATM machines), many economists feel it could still have large positive effects in the long-run, shaking up the corruption, tax evasion, and crime that has long crippled the country. But the long-run gains depend on implementation, and it could take years to know how history will view this unprecedented move.

THE GOAL IS A LESS-CASH SOCIETY NOT A CASHLESS ONE

In The Curse of Cash, I argue that it will likely be necessary to have a physical currency into the far distant future, but that society should try to better calibrate the use of cash. What is happening in India is an extremely ambitious step in that direction, of a staggering scale that is immediately affecting 1.2 billion people. The short run costs are unfolding, but the long-run effects on India may well prove more than worth them, but it is very hard to know for sure at this stage.

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

 

 

 

 

 

This Halloween, a few books that won’t (shouldn’t!) die

If Halloween has you looking for a way to combine your love (or terror) of zombies and academic books, you’re in luck: Princeton University Press has quite a distinguished publishing history when it comes to the undead.

 

As you noticed if you follow us on Instagram, a few of our favorites have come back to haunt us this October morning. What is this motley crew of titles doing in a pile of withered leaves? Well, The Origins of Monsters offers a peek at the reasons behind the spread of monstrous imagery in ancient empires; Zombies and Calculus  features a veritable course on how to use higher math skills to survive the zombie apocalypse, and International Politics and Zombies invites you to ponder how well-known theories from international relations might be applied to a war with zombies. Is neuroscience your thing? Do Zombies Dream of Undead Sheep? shows how zombism can be understood in terms of current knowledge regarding how the brain works. Or of course, you can take a trip to the graveyard of economic ideology with Zombie Economics, which was probably off marauding when this photo was snapped.

If you’re feeling more ascetic, Black: The History of a Color tells the social history of the color black—archetypal color of darkness and death—but also, Michel Pastoureau tells us, monastic virtue. A strikingly designed choice:

In the beginning was black, Michel Pastoureau tells us in Black: A History of a Color

A post shared by Princeton University Press (@princetonupress) on

 

Happy Halloween, bookworms.

Kenneth Rogoff: James S. Henry’s early approach to the big bills problem

Presenting the next post in a series by Kenneth Rogoff, author of The Curse of Cash. You can read the other posts in the series here, here, here, and here.

RogoffMy new book, The Curse of Cash, calls for moving to a “less cash” society by very gradually phasing out big notes. I must mention, however, a closely-related idea by James S. Henry. In a prescient 1980 Washington Monthly article, Henry put forth a plan for rapidly swapping out $100s and $50s. While The Curse of Cash highlights his emphasis on the use of cash in crime, it should have noted his snap exchange plan early on (as it will in future printings).

Rather than gradually eliminate big bills as I suggest in the book and in my earlier 1998 article, Henry argues for having the government declare that large denomination bills are to expire and must be exchanged for new bills at short notice:

A surprise currency recall, similar to those that had been conducted by governments in post-World War II Europe, and Latin America, and by our own military in Vietnam. On any given Sunday, the Federal Reserve would announce that existing “big bills”—$50s and $100s—would no longer be accepted as legal tender, and would have to be exchanged at banks for new bills within a short period. When the tax cheats, Mafiosi, and other pillars of the criminal community rushed to their banks to exchange their precious notes, the IRS would be there to ask those with the most peculiar bundles some embarrassing questions. (Henry, “The Cash Connection: How to Make the Mob Miserable,” The Washington Monthly issue 4, p. 54).

This is certainly an interesting idea and, indeed, the U.S. is something of an outlier in allowing old bills to be valid forever, albeit most countries rotate from old to new bills very slowly, not at short notice.

Henry’s swap plan absolutely merits serious discussion, but there might be significant problems even if the government only handed out small bills for the old big bills. First, there are formidable logistical problems to doing anything quickly, since at least 40% of U.S. currency is held overseas. Moreover, there is a fine line between a snap currency exchange and a debt default, especially for a highly developed economy in peacetime. Foreign dollar holders especially would feel this way. Finally, any exchange at short notice would be extremely unfair to people who acquired their big bills completely legally but might not keep tabs on the news.

In general, a slow gradual currency swap would be far less disruptive in an advanced economy, and would leave room for dealing with unanticipated and unintended consequences. One idea, detailed in The Curse of Cash, is to allow people to exchange their expiring large bills relatively conveniently for the first few years (still subject to standard anti-money-laundering reporting requirements), then over time make it more inconvenient by accepting the big notes at ever fewer locations and with ever stronger reporting requirements. True, a more prolonged period would give criminals and tax evaders lots of time to launder their mass holdings of big bills into smaller ones or into other assets, and at relatively minimal cost. This appears to have been the case, for example, with exchange of legacy European currency (such as German deutschemarks and French francs) for new euro currency. Of course, in most past exchanges (such as the birth of the euro), governments were concerned with maintaining future demand for their “product.” If, instead, governments recognize that meeting massive cash demand by the underground economy is penny wise and pound foolish, they would be prepared to be more aggressive in seeking documentation in the exchange.

Lastly, just to reiterate a recurrent theme from earlier blogs, the aim should be a less-cash society—not a cashless one. There will likely always be a need for some physical currency, even a century from now.

RogoffKenneth 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. His latest book is The Curse of Cash.

Kenneth Rogoff: Just the Big Bills Pazhalsta

Here is the third post in our blog series by Kenneth Rogoff, author of The Curse of Cash. Read the first post here, and the second here

RogoffIn most emerging markets, cash from advanced countries is at best a mixed blessing. On occasion it helps facilitate legitimate business transactions where banking services are inadequate, but it also plays a big role in crime and corruption. Russian news sources have posted pictures of a massive stack of $100 bills, over $120 million worth, found in the home of an official who was supposed to be in charge of Russia’s anti-corruption agency. Of course, as the book discusses, it is folly to think the mass of stashed cash is all abroad. Virtually every estimate suggests that at least half of all U.S. dollars are held domestically. Some have argued that the costs of cash in crime and tax evasion are a “small price to pay” for civil liberties. But this argument applies to banning all cash, and does not really do much to justify the big notes that allow criminals, tax evaders, and corrupt officials to hide, hoard, and port massive amounts.

The book continues to generate a great deal of discussion in general, with many very positive reviews coming in the past two weeks (here, here, here, here, and here, for example). Freakanomics (as always) does an excellent job explaining the ideas and issues, as does the The New Yorker, which also talks extensively about the Swedish experience (covered at the end of chapter 7 in the book).

The UK now has a group campaigning for the country to go cashless by 2020. The group’s webpage echoes many of the arguments made in The Curse of Cash, in particular highlighting how the bulk of cash is used to facilitate crime, tax evasion, and black economy. The group makes the case that coordinated action by stakeholders can accomplish things relatively quickly and effectively without requiring any new legislation. They are definitely on to something. As my book argues, a key feature of cash that distinguishes it from other transactions media that criminals might use is that it can be spent virtually anywhere. If, for example, more and more retailers refuse to take cash (already a trend), that will have a direct impact. While this is very interesting and encouraging, my book argues that society will want to keep small bills indefinitely for a variety of reasons including privacy, dealing with power outages etc. The group’s timeline might be too ambitious—again the book argues that it is important to go slow to allow time for adjustments, to implement policies for financial inclusion, and to allow time to deal with unanticipated issues.

Indeed, virtually all the recent reviews of the book are very attuned to the subtleties of why getting rid of big bills but not small ones might be a happy medium, and The Business Insider has produced an explainer. The recent print reviews also by and large recognize the manifold preparations that negative-interest-rate policy require, and thus why the early experiences in Europe and particularly Japan might be less informative about how negative rates might work in the future than some commentators seem to believe.

Of course, there are still people glued to the past who think the US should go back on the 1800s gold standard (see my discussion of Jim Grant in blog #2), and there are forward-looking thinkers who think that private digital currencies will put governments out of the central-banking business anyway. The book explains why this is nonsense, mainly because the government gets to make the rules in the currency business, and it always eventually wins, albeit sometimes after adapting private sector innovations. The private sector probably first invented standardized coinage, but the government ultimately appropriated the activity. The private sector first invented paper currency, again the government eventually appropriated the activity. The same will almost surely happen with digital currencies, and already government around the world have taken many steps to hinder mainstream use of cryptocurrencies.

On a different note, there are a couple of otherwise very positive reviews which, in passing, allude to a controversy surrounding my 2009 Princeton University Press book with Carmen Reinhart. In fact, there is no controversy around that book, and never has been. In 2013 there was a debate over a short, un-refereed 2010 conference proceedings note. There is an interesting recent discussion of the perils of debt complacency by Reinhart 2016.

RogoffKenneth 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. His latest book is The Curse of Cash.