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.

Rachel Schneider & Jonathan Morduch: Why do people make the financial decisions they make?

Deep within the American Dream lies the belief that hard work and steady saving will ensure a comfortable retirement and a Financialbetter life for one’s children. But in a nation experiencing unprecedented prosperity, even for many families who seem to be doing everything right, this ideal is still out of reach. In The Financial Diaries, Jonathan Morduch and Rachel Schneider draw on the groundbreaking U.S. Financial Diaries, which follow the lives of 235 low- and middle-income families as they navigate through a year. Through the Diaries, Morduch and Schneider challenge popular assumptions about how Americans earn, spend, borrow, and save—and they identify the true causes of distress and inequality for many working Americans. Combining hard facts with personal stories, The Financial Diaries presents an unparalleled inside look at the economic stresses of today’s families and offers powerful, fresh ideas for solving them. The authors talk about the book, what was surprising as they conducted their study, and how their findings affect the conversation on inequality in a new Q&A:

Why did you write this book?
We have both spent our careers thinking about households and consumer finance, and our field has reams and reams of descriptive data about what people do—savings rates, the number of overdrafts, the size of their tax refunds. We have lots of financial information but very little of the existing data helped us understand why—why people make the financial decisions they make, and why they get tripped up. So we decided to spend time with a group of families, get to know them very well, and track every dollar they earned, spent, borrowed, and shared over the course of one year. By collecting new and different kinds of information, we were able to understand a lot of the why, and gained a new view of what’s going on in America.

What did you learn about the financial lives of low- and moderate-income families in your year-long study?
We saw that the financial lives of a surprising number of families looks very different from the standard story that most people expect. The first and most prominent thing we saw is how unsteady, how volatile households’ income and expenses were for many. The average family in our study had more than five months a year when income was 25% above or below their average.

That volatility made it hard to budget and save—and it meant that plans were often derailed. How people were doing had less to do with the income they expected to earn in total during the year and more to do with when that income hit paychecks and how predictable that was. Spending emergencies added a layer of complexity. In other words, week-to-week and month-to-month cash flow problems dominated many families’ financial lives. Their main challenges weren’t resisting temptation to overspend in the present, or planning appropriately for the long term but how to make sure they would have enough cash for the needs they knew were coming soon.

The resulting anxiety, frustration, and a sense of financial insecurity affected families that were technically classified as middle class.

How does this tie into the economic anxiety that fueled Trump’s election?
The families we talked to revealed deep anxieties that are part of a broader backdrop for understanding America today. That anxiety is part of what fueled Trump, but it also fueled Bernie Sanders and, to an extent, Hillary Clinton. A broad set of the population feels rightly that the system just isn’t working for them.

For example, we met Becky and Jeremy, a couple with two kids who live in small town Ohio where Trump did well. Jeremy is a mechanic who fixes trucks on commission. Even though he works full-time, the size of his paychecks vary wildly depending on how many trucks come in each day. This volatility in their household income means that while they’re part of the middle class when you look at their annual income, they dipped below the poverty line six months out of the year.

One day we met with Becky, who was deciding whether or not to make their monthly mortgage payment a couple of weeks early. She had enough money on hand, but she was wavering between paying it now so she could rest easy knowing it was taken care of, or holding onto the money because she didn’t know what was going to happen in the next couple weeks, and was afraid she might need the money for something else even more urgent. She was making decisions like this almost every day, which created not only anxiety but a sense of frustration about always feeling on the edge.

Ultimately, Jeremy decided to switch to a lower-paying job with a bigger commute doing the exact same work – but now he’s paid on salary. They opted for stability over mobility. Becky and Jeremy helped us see how the economic anxiety people feel is not only about having enough money, but about the structure of their economic lives and the risk, volatility, and insecurity that have become commonplace in our economy.

One of the most interesting insights from your book is that while these families are struggling, they’re also working really hard and coming up with creative ways to cope. Can you share an example?
Janice, a casino worker in Mississippi, told us about a system she created with multiple bank accounts. She has one bank account close to her she uses for bill paying. But she also has a credit union account where she has part of her paycheck automatically deposited. This bank is an hour away, has inconvenient hours, and when they sent her an ATM card, she cut it in half. She designed a level of inconvenience for that account on purpose, in order to make it harder to spend that money. She told us she will drive the hour to that faraway bank when she has a “really, really need”—an emergency or cost that is big enough that she’ll overcome the barriers she put up on purpose. One month, she went down there because her grandson needed school supplies, which was a “really, really need” for her. The rest of the time, it’s too far away to touch. And that’s exactly how she designed it.

We found so many other examples like this one, where people are trying to create the right mix of structure and flexibility in their financial lives. There’s a tension between the structure that helps you resist temptation and save, and the flexibility you need when life conspires against you. But we don’t have financial products, services, and ideas that are designed around this need and the actual challenges that families are facing. This is why Janice has all these different banks she uses for different purposes—to get that mix of structure and flexibility that traditional financial services do not provide.

How does this tie into the conversation we’ve been having about inequality over the last decade or so?
Income and wealth inequality are real. But those two inequalities of income and assets are hiding this other really important inequality, which is about stability. What we learned in talking to families is that they’re not thinking about income and wealth inequality on a day-to-day basis—they’re worrying about whether they have enough money today, tomorrow, and next week. The problem is akin to what happens in businesses. They might be profitable on their income statement, but they ran out of cash and couldn’t make payroll next week.

This same scenario is happening with the families we met. We saw situations where someone has enough income or is saving over time, but nonetheless, they can’t make ends meet right now. That instability is the hidden inequality that’s missing from our conversation about wealth and income inequality.

How much of this comes down to personal responsibility? Experts like Suze Orman and Dave Ramsey argue you can live on a shoestring if you’re just disciplined. Doesn’t that apply to these families?
The cornerstone of traditional personal finance advice from people like Orman and Ramsey is budgeting and discipline. But you can’t really do that without predictability and control.

We met one woman who is extremely disciplined about her budget, but the volatility of her income kept tripping her up. She is a tax preparer, which means she earns half her income in the first three months of the year. She has a spreadsheet where she runs all her expenses, down to every taxi she thinks she might need to take. She budgets really explicitly and when she spends a little more on food one week, she goes back and looks at her budget, and changes it for the next few weeks to compensate. Her system requires extreme focus and discipline, but it’s still not enough to make her feel financially secure. Traditional personal finance advice just isn’t workable for most families because it doesn’t start with the actual problems that families face.

What can the financial services industry do to better serve low- and moderate-income families?
The financial services industry has a big job in figuring out how to deal with cash flow volatility at the household level, because most of the products they have generated are based on an underlying belief that households have a regular and predictable income. So their challenge is to develop new products and services—and improve existing ones—that are designed to help people manage their ongoing cash flow needs and get the right money at the right time.

There are a few examples of innovative products that are trying to help households meet the challenges of volatility and instability. Even is a new company that helps people smooth out their income by helping them automatically save spikes, or get a short-term “boost” to cover dips. Digit analyzes earning and spending patterns to find times when someone has a little extra on hand and put it aside, again automatically. Propel is looking to make it much easier and faster for people to get access to food stamps when they need them. There are a number of organizations trying to bring savings groups or lending circles, a way of saving and borrowing with friends and family common everywhere in the developing world, to more people in the United States.

There is lots of scope for innovation to meet the needs of households—the biggest challenge is seeing what those needs are, and how different they are from the standard way of thinking about financial lives and problems.

Jonathan Morduch is professor of public policy and economics at the New York University Wagner Graduate School of Public Service. He is the coauthor of Portfolios of the Poor (Princeton) and other books. Rachel Schneider is senior vice president at the Center for Financial Services Innovation, an organization dedicated to improving the financial health of Americans.

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.


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.


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

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.


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.

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: 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.


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.


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.


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.


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






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.

Kenneth Rogoff: Negative interest rates are an emotional topic, too

Presenting the second post in a blog series by Kenneth Rogoff, author of The Curse of Cash. If you missed the first installment, read it here.


The book continues to create a vigorous debate about moving to a less-cash (not cashless) society with only smaller denomination bills; you can see various TV and radio discussion here. Below I’d like to respond to a provocative review in the Wall Street Journal.

But first a few other points that have come up: the gun lobby continues to seem particularly exercised about losing large bills. Perhaps the concern is that without convenient large notes, the government might have an easier time enforcing registration and background checks on people who buy firearms. A broader take is the American Thinker piece “Washington’s Endgame: First Your Guns Then Your Cash.” I can only say that I am not very sympathetic.

I try in the book to efficiently cover every possible misconception that people might have about where all the missing big bills are (even the spirit world), but I am afraid I missed one. Writing in the Numismatic News, Patrick A Heller suggests that we all should know “that a sizeable percentage of this (missing cash) is held by central banks as reserves.” Well, not really. Foreign central-bank dollar holdings are almost entirely in the form of electronic bills and bonds. Some foreign banks do hold physical U.S. dollars to meet customer demand, but most world holdings of dollars are in the underground economy (crime and tax evasion). As the book discusses extensively, foreign demand mostly likely accounts for less than 50% of total U.S. dollars outstanding.

In his thoughtful Finance and Development review, Peter Garber asks why not just make $100 bills larger and bulkier, then we don’t need to get rid of them. Well, if we make them ten times heavier and ten times bulkier, yes, that would be another approach (albeit not equivalent to mine, because tenfold oversized notes would be easier to tabulate, and you could probably pack them tighter unless the bills are larger still). But seriously, what is the difference, the symbolism? Anyway, I have no objections to leaving a giant $100 bill for collectors. Garber also argues that if the physical dollar becomes less prominent internationally, the electronic dollar will suffer. Maybe once upon a time that was true, but it is almost irrelevant today in the legal tax-paying world, domestic or foreign. Also, let’s not forget my plan leaves plenty leaves small bills, so the symbolism is still there.

This takes us to Jim Grant’s Wall Street Journal review. Several people I respect think Grant is a very smart guy who likes to be provocative, but I would to take up some of his simple errors and profound misconceptions.

Grant has little interest in the main part of the book, which argues that the large notes, which dominate the currency supply, do far more to facilitate tax evasion and crime than legal transactions. He posits that it would be so much simpler to legalize narcotics and simplify taxes, and that “Mr. Rogoff considers neither policy option.” In point of fact, I address legalizing marijuana on page 69, and the book goes on to detail the many other ways cash is used in crime besides drugs: racketeering, money laundering, human trafficking, extortion, corruption, you name it. Simplifying taxes is a great idea with lots of efficiency benefits I have written often about. But to think that any realistic simplification plan would end tax evasion is delusional.

Grant focuses his ire almost entirely on negative interest rates, saying “You rub your eyes. You can recall no precedent. There has never been one in 5,000 years of banking.” Well, Grant is known for his interesting historical analyses, but this statement is misleading at best. Before paper currency, governments routinely paid negative interest rates on metallic currencies by calling in coins and shaving them (as I discuss at some length in chapter 2). That might not immediately imply a negative rate on other debt instruments, but if your debt is repaid in physically debased pence that have much less silver than the ones you lent, it is a negative interest rate in any meaningful sense.

In modern times, the existence of paper currency prevents any significant negative rate on other government debt because of fear of a run on cash, though Europe and Japan have managed to get away with slight negative rates. So the statement that this has not happened until now is, well, hardly profound. Besides, there have been countless episodes of significant negative real interest rates on government bonds, that is when the nominal (face value) interest rate is not nearly enough to keep up with inflation, for example in the 1970s, when inflation went over 13% in the U.S. and over 20% in the U.K. and Japan.

In any event, my plan excludes small savers. And if effective negative-rate policy were possible, it would likely be quite short lived, and would probably cause a lot less problems that a decade of zero rates or high inflation. If the Fed could engage in effective monetary policy in a deep recession, most savers will gain far more than they will lose. It would bring back jobs more quickly, restore house and stock prices faster, and it would actually raise nominal rates on long-term bonds through restoring expected inflation to target. The suggestion that negative rates are just a policy to rob savers is empty polemic.

In chapter 12, I discuss populist perspectives on central banking, including Ron Paul and a return of the gold standard. Grant, evidently, was tapped to be Paul’s Fed Chairman had his 2012 presidential campaign been successful. On CNBC Squawkbox, Grant compares Fed chair Ben Bernanke to the head of Zimbabwe’s central bank, because he is just sure that all the “money printing” Bernanke was doing would lead to high inflation. Of course, what Bernanke was doing was not so much printing money as exchanging short-term central bank reserves for long-term government debt, as a reader of chapter 9 would understand. (And critically, the government fully owns the central bank.) I am not a big believer in the wonders of quantitative easing, but those who predicted that it would lead to very high inflation made an epic wrong call. Grant not only hates negative rates, he says he doesn’t like zero rates, and said back then the Fed should promptly raise them. Many other central banks, including the European Central Bank, tried just that—the results were disastrous.

Lastly, it is worth mentioning that by and large the financial industry lobbies heavily against negative rates. Leading financial newspapers regularly publish articles by banking industry proponents that argue how negative rates will deter governments from pursuing structural reform. Some of their arguments—about the problems with implementing negative rates today, having to with institutional, tax, and legal issues that need to be fixed before negative rates can be effective—are legitimate. The Curse of Cash addresses all that, and explains that it will take a long time even if the problem of a run into cash is taken off the table. Ultimately, banks make money off the difference between the rates they pay to borrow and the rates they charge to lend, and once the preparations are made, they will not have cause to complain.

In the end, if global real interest rates stay low for the next decade, there will likely be occasional periods of negative rates during recessions in most advanced economies, whether we like it or not. Part II of the book explains how to make negative rate policy better and more effective. Anyone who wants to understand it should read The Curse of Cash.

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.

Kenneth Rogoff: Cash is an emotional topic

Read on for the first post in a blog series by Kenneth Rogoff, author of The Curse of Cash:

In The Curse of Cash, I make a serious case for phasing out the bulk of paper currency, particularly large denomination notes. Since pre-publication copies started floating around just a few weeks ago, a number of engaging, thoughtful reviews have published (for example, here, here, here, here and here). But mere rumors of the book’s impending publication have also evoked an extraordinary number of visceral comments (online and by email): “This idea is almost as bad as banning semi-automatic weapons,” is one theme. Another is, “Why should people feel guilty about doing business in cash to avoid paying taxes when we all know the government will just waste the money?” Having first explained two decades ago why governments that print big bills are penny-wise and pound-foolish, I am well familiar with how emotional this topic can be.

There have also been some comments having to do with individual liberty and wondering if criminals will use other currencies and transactions media. I address these and many other serious concerns in the book, and I have tried to do so in a clear and engaging way that anyone can understand. But here is a quick version to straighten out some key points:

The most fundamental point is to emphasize that the book argues for a less-cash society, not a cash-less one. There is a world of difference. If the U.S. first phased out one hundred-dollar bills and fifty-dollar bills, and then after perhaps two decades phased out twenty-dollar bills, there would still be ten-dollar bills and below. I strongly argue these should be left around indefinitely, and explain why it would be a mistake to withdraw cash entirely, as opposed to just larger bills. Even if we get down to ten-dollar bills, making an anonymous cash purchase of $1,000 would still be pretty easy—and even a $100,000 purchase would require only a briefcase. The aim of my proposal is to get at wholesale tax evasion by businesses and higher-income individuals, and by large-scale criminal enterprises, e.g., drug lords and crime bosses. With ten-dollar bills and below—which will be left in place indefinitely—there will always be ways for ordinary people to make private (anonymous) payments and for low-income individuals to buy groceries.

Any reader of the book will see that I am not proposing getting rid larger bills as segue to an outright abolition of cash—I explain why I’m against eliminating physical cash into the very distant future, perhaps another century. But for all the advantages of cash, we have to recognize that the current system is badly off kilter. A lot of central banks and finance ministries know it, as do justice departments and tax authorities.

What about the argument that in lieu of big bills, criminals and tax evaders are always going to find other ways to make anonymous payments? Obviously this is an important point, and one that comes up throughout in the book. But there is a reason why cash is king. No other anonymous transactions vehicle, however, is as remotely easy to use. Gold coins have to be weighed and assayed, and can hardly be spent at the tobacco shop. Uncut diamonds are even less liquid. Bitcoin is somewhat anonymous (albeit traceable in many instances), but governments have been putting up all sorts of tax rules and restrictions on financial institutions that make it a very poor substitute for cash. And by the way, governments will continue to do this with any new transaction media they view as facilitating tax evasion, money laundering, and crime. As I explain in the book, big bills facilitate big crime—taking them out of circulation will have a significant effect.

Finally, another very early comment on the book, of a vastly different type, is from someone I greatly respect but do not always agree with, Edward Chancellor. Unfortunately, he makes a couple of absolutely critical misrepresentations. Most importantly, he seems happy to blur the critical distinction between “less cash” and cashless. He slips easily into the “cashless” phraseology, for example, when wondering how to give money to beggars in my world. I am impressed if he can give out one hundred-dollar bills to beggars, but if so, I think he would find that a fistful of tens is also welcome.

I agree with Edward that to take advantage of today’s ultra-low real interest rates, it would be a good idea for governments right now to issue very long-term bonds (see my recent article); I have no objections to his preferred perpetuities. But there is an enormous difference between issuing registered perpetual bonds and issuing anonymous currency; that is my whole point. By the way, as the book notes, anonymous bearer bonds were effectively killed a long time ago.

Edward and I disagree on negative interest rates, but that it is whole different can of worms. I’ll just say that, in addition to explaining the issues, the section in the book on negative rates shows that effective negative-interest-rate policy is going to require laying many years of ground work—not a recommendation for something the ECB or the Bank of Japan can do tomorrow. But for reasons discussed, it is by a wide margin the best plan for the future. All the others are much worse.

In the meantime, anyone who has looked serious at the data will realize that even as currency use is declining in the legal economy, it is growing in the underground economy. Something is badly out of whack, and it is time to have a serious discussion about it.

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.