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Deregulation, Italian Style

Saturday, December 1, 2012

Luigi Zingales. A Capitalism for the People: Recapturing the Lost Genius of American Prosperity. Basic Books. 287 Pages. $27.99.

When milton Friedman retired from the University of Chicago in 1977, I feared the school would become more focused on technical economics and lose the passionate pro-free-market edge that Friedman represented.  To some extent, that has happened. Also, I wondered who in the next generation would replace him. Although many of us aspire to “be like Milton,” unfortunately no one can replace Friedman’s exquisite mix of technical expertise, ability to write clearly for the public (much of which he owed to his editor and wife, Rose Friedman), and warm openness in debate.

Still, as we economists like to say, there are substitutes for everything and everybody. In some important respects, one substitute for the late Milton Friedman is Luigi Zingales. Zingales, an immigrant from Italy, is an economics professor in the University of Chicago’s Graduate School of Business, a strong technical economist and a passionate defender of free markets. He’s also an excellent writer. In his latest book, A Capitalism for the People, he makes a case for freer markets and warns people in his adopted nation not to go the way of the country he left. He sees disturbing signs that the United States is heading in that direction. Thus the book’s subtitle: “Recapturing the Lost Genius of American Prosperity.” Zingales brings a refreshing touch to many of the issues he discusses, especially the ethics of the market and the dangers of cronyism.  He draws on his own and others’ scholarly research, plus his detailed knowledge of financial markets, to make his case for freer markets more than just a theoretical one. Unfortunately, he gets some important parts of U.S. economic history wrong. Also, although he lays out many ways in which financial regulation has gone wrong, his own proposals are either for only modest deregulation or for new regulation. And despite brilliantly analyzing the incentives of financial regulators that cause them to harm the economy, he advocates his own set of regulations that would still require regulators we can trust.

“No man is a prophet in his own land” goes the saying, and one reason why Zingales’s message is fresh is that, coming from a country with a great deal of cronyism, he sees just how stultifying cronyism can be. Zingales contrasts Italian cronyism with U.S. meritocracy. He points out that the way to get ahead in Italy is to “carry the bag” of an established person. Even emergency room doctors are chosen, he writes, based mainly on political affiliation rather than on skill. By contrast, in the United States, many more people get ahead based on their merit. Zingales tells the story of a young colleague walking in the rain with a senior professor. The senior professor told the junior one, “In Europe, the young assistant professors carry the umbrella for the senior ones.” The young professor shot back, “Why don’t you go to Europe?”

But Zingales sees all of America going in Europe’s direction. He gives many examples of U.S. influence peddling. One of the most striking examples, because of the prominence of the person involved, is that of Robert Rubin. When Rubin was Treasury secretary under President Bill Clinton, Citigroup acquired the Travelers insurance company. That move was illegal, but Travelers’ ceo Sandy Weil explained that he had had enough discussions with the Treasury and the Federal Reserve Board to “believe this will not be a problem.” Rubin lobbied for a change in the law to make Citigroup’s action legal after the fact, and in July 1999, the House of Representatives passed the law. The next day Rubin quit as Treasury secretary. Just three months later, Citigroup hired Rubin at a salary of $15 million, without, writes Zingales, “any operating responsibility.”

It soon became clear, though, what was part of Rubin’s responsibility: to play an inside game with the Treasury bureaucracy to benefit his new employer. In 2001, following revelations of “accounting irregularities” at Enron, Citigroup, a major holder of Enron’s bonds, would have lost a lot of money had Enron’s bonds been downgraded. So Rubin lobbied Peter Fisher, undersecretary of the Bush Treasury, to “advise” the bond-rating agencies not to immediately downgrade Enron’s debt. And in 2008, the Wall Street Journal reported that Rubin had been “critical to securing the latest federal bailout of Citi.” The bailout included two “equity infusions” totaling $45 billion and a government guarantee on most of the risk in a $306 billion asset portfolio. This is cronyism writ large.

Zingales’s expertise is in finance, and that fact is apparent throughout the book. He tells, for example, of a tiny section of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act that destroyed Lehman Brothers. Under the law, when Lehman went bankrupt, it couldn’t simply, as it could have before the 2005 law, pay holders of derivatives as much as possible with its assets. Instead, it had to give a derivative holder a contract identical to the one it had signed with Lehman, but with a different counterparty. Lehman would have to pay the transaction cost of the new contract. A typical such cost is about 0.15 percent of the contract’s total value. That doesn’t sound like much until you realize that when it went bankrupt, the face value of Lehman’s derivative contracts was $35 trillion! So the transactions costs alone were $52.5 billion. That’s why Lehman’s bonds paid only 8.625 cents on the dollar.

For those who still think that corporate boards of directors, outside auditors, or financial regulators do a good job of detecting corporate fraud, Zingales has news: It’s “nobody’s job to detect fraud” (his italics). He tells of a friend, a board member of a large company, who once asked the head of purchasing “what prevented him from overpaying for an item and having part of the difference rebated to a secret Swiss bank account.” A lawyer on the board responded that board members “were responsible for making sure that procedures existed, not that they were effective!” Boards of directors, notes Zingales, “rely on external auditors to detect fraud.”

It turns out, though, that external auditors “do not view fraud detection as their responsibility.” He notes that accountants have deemphasized fraud detection and instead focus on adherence to formal rules. Zingales tells of a study he co-authored in which he found that external auditors were responsible for only ten percent of fraud detection.

Well, then, surely financial regulators are set up to detect fraud, aren’t they? Not quite. When Zingales presented his findings on fraud detection at the Securities and Exchange Commission, he was told that it is not the sec’s job to detect fraud. True to its word, the sec accounts for only seven percent of total fraud detected. In seventeen percent of the cases that Zingales and his co-authors studied, single employees at firms had blown the whistle, “often at high personal cost.”

So, what should be done about fraud? Zingales advocates appointing board members who are accountable to the shareholders. He argues that this is not possible today because of regulation introduced by the sec during the Vietnam War era, but does not specify what that regulation was.

I was disappointed that Zingales didn’t address other regulations that promote fraud in companies — two in particular. Section 13(d) of the Williams Act of 1968, for example, requires that investors who garner five percent or more of the shares of a company must announce that fact within ten days. That one law makes it virtually impossible for an entity that wants to take over another company to do so cheaply. Once it is known that an investor has over five percent, the price of the company’s shares rises because there is now a higher probability of a takeover attempt. The increase in share prices of the target company discourages people from attempting takeovers in the first place. Also, a slew of state anti-takeover laws passed in the 1980s also make takeovers harder. Why does this matter? Because takeovers and threatened takeovers are a way of disciplining firms that are destroying shareholder value, fraudulently or otherwise.

Surprisingly, Zingales also advocates increased regulation. Although he only hints at it in the book, he has, more recently, explicitly advocated “the forced separation between investment banking and commercial banking along the lines of Glass-Steagall.” Zingales realizes that the 1999 Gramm-Leach-Bliley Act’s repeal of that forced separation was not a cause of the 2008 financial crisis. He points out that the major financial institutions that failed during the crisis were either pure investment banks such as Lehman Brothers, Bear Stearns, and Merrill Lynch, or purely commercial banks such as Wachovia and Washington Mutual.

So, what is Zingales’s case for reintroducing Glass-Steagall? He hints at a reason: A mandatory separation would undercut the financial industry’s lobbying clout — a clout that I agree has been, on net, bad. In a recent op-ed, Zingales gave another reason. He admitted that a better way to deal with excessive risk-taking by banks is to remove deposit insurance. His only argument against doing so is that he doubts that “commercial banks are ready for that.” But so what? Does Zingales, who is an outspoken enemy of cronyism, advocate that we cave to the banking lobby? Moreover, even if we worry, as he does, about political feasibility, there’s another way to make banks and depositors bear more risk from banks’ bad lending decisions: Leave the depositor with some of the risk. Marc Joffe and Anthony Randazzo of the Reason Foundation, for example, advocate adding “a 10 percent co-insurance feature to fdic insurance for deposits above $10,000.” Under their proposal, depositors with $11,000 in a failed bank would receive $10,900, and those with a $250,000 balance would get $226,000. That would give depositors an incentive — they have virtually none now — to monitor the banks that hold their deposits.

When it comes to what business schools should teach about ethics, Zingales’s book is a breath of fresh air.  Business schools should be “the churches of the meritocratic creed.” They should lead the way, he argues, in promoting “norms that discourage behavior that is purely opportunistic even if highly profitable.” A way to do so is to award prizes to “outstanding alumni who adhere to economically useful norms.” Zingales has a beef with the two main ways that ethics classes are currently taught at most business schools. One is to raise ethical dilemmas without taking a position on what people should do. That, he says, is like presenting the “pros and cons of racial segregation, leaving [people] to decide” the answers for themselves. The other way is to hide behind “corporate social responsibility,” which, he points out, ignores individual responsibility. To those who wonder why a business school should teach ethics, Zingales asks a beautiful rhetorical question: “Why are economists happy to say what the optimal laws are from an economic standpoint but afraid to say what the optimal social norms are for a successful economy?”

In a chapter entitled “Responsibil-ities of the Intellectuals,” Zingales gives an excellent explanation — and some striking examples — of how biases can creep in and distort the perceptions of even very smart people. One reason for the biases, he writes, is the pressure that academics feel from people or companies with large stakes in the outcomes of their research. His best example is of a young finance professor who found that people who traded stocks on regional exchanges got a worse deal than those who traded on the New York Stock Exchange. It turns out that some market makers were paying brokers a penny a share to route orders to them. But then a senior colleague called the young researcher into his office, where “he was confronted by a large market maker who berated him.” The young assistant professor was intimidated into dropping that research. The identity of the market maker who intimidated the researcher? Bernard Madoff.

Ironically, one interesting piece of evidence for Zingales’s idea that even a smart ethical person can let biases creep in is a section of this very chapter in which Zingales himself pulls his punches. He quotes a Federal Reserve governor who, in December 2006, pooh-poohed housing-price data on the grounds that such data, because they’re imperfect, are not very useful. Zingales does not name the Fed governor, but does footnote the web site where one can find out. It was Randall Kroszner. Why is that demurral significant? Because Kroszner is one of Zingales’s colleagues.

Zingales is a master of the metaphor. In discussing Bush’s Troubled Asset Relief Program, for example, he points out that he doesn’t necessarily reject government action but objects to the way it is done. When a drug addict is undergoing withdrawal, he notes, one shouldn’t do nothing, “but one also should not give the addict a full year’s supply of drugs, which is roughly equivalent to what the U.S. government opted for” with the bailout. He also compares subsidizing businesses to “feeding wild animals.”

When he ventures outside his expertise, though, Zingales sometimes makes important mistakes. For example, he states that the antitrust law was passed in the late 19th century to increase competition. But Loyola University economics professor Thomas DiLorenzo, in some pathbreaking research in the 1980s, showed the opposite. Between 1880 and 1890, he found, while real gross domestic product rose 24 percent, real output in the allegedly monopolized industries for which data were available rose 175 percent, seven times the economy’s growth rate. In six of those seven industries, inflation-adjusted prices fell, which is strong evidence against the view that the large firms were monopolizing. DiLorenzo shows that a key faction lobbying for antitrust laws were small firms that had trouble competing with big firms with large economies of scale, and these small firms wanted less competition, not more. It’s still true today that some of the main bringers of antitrust suits are companies suing their competitors. They don’t want their competitors to charge even lower prices.

In discussing government policy, Zingales reminds us of what ucla and former University of Chicago economist Harold Demsetz calls the “Nirvana Fallacy,” although he mistakenly attributes it to Ronald Coase. The Nirvana Fallacy is to see a problem with the free market and then to assume that the government can solve it. Demsetz advocated comparing actual markets and actual governments. Zingales does a good job of applying the Demsetzian thinking to other people’s proposals for government policy, but not as good a job at applying it to his own. For example, he advocates “timely intervention of the regulator” when regulators observe a sizeable drop in the price of a traded security. But he doesn’t tell us why regulators will be motivated to act.

The vast majority of readers will learn a lot from A Capitalism for the People. I’m glad that Luigi Zingales wrote it. I only wish that he had more seriously considered a wider range of deregulatory moves that would help steer the United States away from the dangerous path down which he and I agree it’s moving.