Bigger is Better

It seems a requirement of modern politics that Democrats criticize big business and Republicans criticize big government.

There is one problem with these shibboleths, these tests of the faithful: they ignore how the interplay between big government and big business has made us prosperous. History suggests that any politician successful at impeding either government or business will effectively slow economic progress.

Some people know the amazing story of Elisha Gray arriving at the patent office just hours after Alexander Graham Bell with his patent application for the phone. Bell went on to fame and fortune and Gray to a life of anonymity. There’s more to it, though. Our founding fathers were intent on creating an accessible, affordable patent system. One might even say it was democratic. Fewer people know that the Italian Antonio Meucci had invented the telephone years – not just hours – before Bell but could not afford to patent it through Italy’s expensive patent system. Had Italy been more visionary about subsidizing the work of its inventors by making it cheaper to file for a patent, it may have hosted the myriad, great inventions that defined the decades around 1900 or had the equivalent of Bell Labs from which communication satellites and transistors emerged as catalyst for huge industries. Our government enabled invention.

In his book The Rise and Fall of American Growth, Robert Gordon shares this story of Bell, Gray and Meucci and gives a host of other examples of government and business interacting to create prosperity.

During the second world war, the federal government led initiatives to increase industrial capacity. The government invested capital equal to half the capital that existed at the start of the war, capital in the form of factories and machine tools (which doubled during the war). Even better was the problem-solving that resulted in better production methods. During the war, Kaiser initially took 8 months to complete a ship; they accelerated that to just a few weeks by the next year. A plane factory of Ford's increased its rate of 75 planes per month in February of 1943 to 432 per month by August of 1944. By D-Day, the Germans could launch only 319 aircraft; the US and its allies launched 12,837. American factories won the war.

After the war, the government turned all this over to private companies. Armed with these investments in capital and knowledge, these companies began making consumer products like cars and TVs. Before the second world war, the economy had lurched in and out of recession. After, it took off. Government regulations helped raise wages and government investment helped raise productivity. Workers both made and bought these new products.

Eisenhower had been a solider during the first world war and was part of a group transporting vehicles across the US. It took them 62 days to go from coast to coast. Head of the Allies’ conquering army, he experienced first-hand the German autobahn and was amazed at the contrast. The interstate highway legislation Eisenhower signed increased American productivity by tens of percent.  Like the railroads the government subsidized a century earlier, the highway system gave customers and producers easier, more affordable access to products and markets. Decades earlier, life expectancy had gone up as a result of similar, local efforts to build out the infrastructure that brought safe water into homes and piped sewage out, another initiative dependent on the cooperation of government and business.

Another outcome of the second world war was increased investment in research and education. In WWII we didn't just pump unprecedented amounts of money into research but FDR asked Vannevar Bush to institutionalize that, which he did with what become the NSF (National Science Foundation) and DARPA (the Defense Advanced Research Projects Agency). From DARPA we got the Internet which has enabled the creation of trillions in new wealth and millions of new jobs. The GI Bill was another product of the second world war and it led to a huge increase in college enrollment, creating a new generation of better educated, more productive workers.

Possibly the most important interplay between big government and big corporations comes in R&D. Research is hugely uncertain and most of it results in nothing. If it does result in something cool it may happen a decade or three later than expected. Also, not every cool thing becomes profitable. Because of this, corporations rarely finance basic research and it needs to be heavily funded by institutions like DARPA or the University of California. This research is crucial to corporations' later developments. "The parts of the smart phone that make it smart—GPS, touch screens, the Internet—were advanced by the Defense Department," as Mariana Mazzucato points out in her book The Entrepreneurial State. Corporations try to find a way to translate research that has taken one to two decades into development that takes two to four years. It's a great system and at its best we tax successful corporations to fund the next round of research which could be transformed into new products by corporations. Symantec and Qualcomm were among the new companies funded by The Small Business Innovation Research program - a program started by Ronald Reagan. Google's basic algorithm was funded with a NSF grant.

Of late, our policies seem less reflective of this interdependence. As corporations pay less in taxes the government has less money for initiatives that could help the next generation of companies and workers to prosper. Our productivity, wages and GDP were growing faster during a time when corporate tax rates were maxed out at about 50% and personal income tax rates maxed out at about 70%. The trick is to tax what is successful now to fund what will become successful next.

Government has an important job as a referee, a role Elizabeth Warren articulates well. Government has an important job of moderating wealth and income inequality. (Trump looked at the world with the biggest gap between rich and poor in history and concluded that the rich were not rich enough and the poor were not poor enough, giving the first a tax break and cutting assistance to the second. Few people would reach such a conclusion.) Those jobs of referee and moderator are important but over the long term, they are not as important as the job of collaborating with business and labor to create the next generation of technologies, products, industries and companies. It is in that direction that lies the kind of progress we had from 1900 to 2000 that increased real incomes by 8X and let us buy myriad objects like airplane tickets, personal computers and antibiotics that did not even exist at the start of the century.

The world is full of communities who would love our problem of big government and big business. Big projects are not done by small organizations. It should be a cliché to say what is too rarely said: progress is not a product of markets or democracies but rather their interaction. Strong companies and strong government go together in vibrant economies. Even within the US, the states that keep taxes and investment lower and have few big companies have lower household income and create fewer jobs. Big businesses and government agencies are not a sign that we’re off the rails. They are, instead, the way we got both the rails and the trains.

Age is Just a Number. Then Again, So Are the Votes You Need to Win

Our last four presidents were all baby boomers.

Clinton, Bush, and Trump were all born within a year of when Japan's surrender ended WWII. Fittingly, the impulsive Trump was born a mere 9.5 months after.

Obama gets lumped in with that generation by demographers but was born 16 years after WWII ended. Less boom than echo.

Clinton, Bush and Trump time traveled together, hitting all the major events at the same age.

It is not just that the 2020 candidates include what could be the first Jew, black, woman, black woman, or gay to be president. It also includes members of the silent generation, baby boomers, gen x, and a millennial. These candidates have hit major events at very different stages of life and would bring a very different perspective to them. Bernie Sanders was 4 when Japan surrendered and the horrors of World War II would have been relayed to him as fresh stories by family members when he was a little boy rather than as distant history as it would have been for Pete Buttigieg who will be younger when he's sworn in than Sanders was when Buttigieg was born.

Here is a way to think about the age of the candidates in terms of where they were when historic events happened. (And obviously for the candidates, the age when "sworn into office" assumes that they would actually win the 2020 election.)

Oh, and yes. I know that Ocasio-Cortez is too young but I thought it was interesting to put her there for comparison. And she's too young for 2020 but she'll be old enough by 4 months to run in 2024.

Two Financial Regulation Models: NFL or WWE

One of the most dangerous things about a Trump presidency is what it could mean for financial regulation.

This weekend millions of Americans will watch football, a sport punctuated by flags, whistles, and officials calling back a run because someone cheated when blocking or granting yards on a failed pass because someone cheated when defending a receiver. The game is fiercely competitive and highly regulated. Americans love it. The teams want your money but they also want to win. All of them. And they have to follow clear rules that ensure that the competition involves football skill, not thuggery.

Far fewer will watch World Wrestling. Entertainment. At the WWE, the officials are props who circle the fighters and hopelessly flail, even when one of the fighters grabs a chair to hit the other over the head. This game is not competitive, as winners and losers are often negotiated beforehand. It's rigged. The wrestlers want your money but winning or losing is just part of their job. It's less about competition than theater.

Trump has hosted WWE events at his properties and has body slammed a guy whose head he later shaved. He and the Republicans in Congress largely believe that financial markets are self-correcting and don't really need regulation, suggesting that their ideal referee is more WWE than NFL.

Let's review what that means and start with a review of the Great Recession because it is so easy to forget.

The Great Recession
After January 2008, employment fell for 25 straight months - the longest streak since the 1930s. By February 2010, the "job deficit" was 12 million. (The job deficit equals the number of jobs lost plus the number of jobs that would have normally been created during that time. The economy destroyed about 8 million jobs in a period when it would have normally created about 4 million. Add them up and you're short 12 million jobs compared to any normal period.)

Long-term unemployment as a percentage of unemployment swung between 5% and 20% of total unemployment in the period after 1948. By April of 2010, it had hit 45% and would take years to drop to its old level.

GDP growth, too, was slow to recover. After the last two recessions GDP grew 6.2 and 5.6 percent in the years right after the recovery. This time it grew about 2%.

Between housing and financial assets, wealth fell about $18 trillion, an amount equal to annual GDP.

[All of these stats from Alan Blinder's After the Music Stopped: the financial crisis, the response, and the work ahead.]

These seem like cold stats. They're not. They represent millions who were made homeless, had careers and retirement plans derailed, and were unable to do things like help children with a college education or buy a car or pay a medical bill. They represent millions whose lives were set back. According to one study, the trauma of the Great Recession provoked 10,000 suicides and that is just the most extreme emotional consequence of an economy this brutal.


What Caused this Financial Crisis?

I think that a few things caused it.

Martin Wolf writes of the lead up to the 2007 - 8 Great Recession that "risk had been distributed not to those best able to bear it, but to those least able to understand it." Local bankers were less likely to own mortgage loans than remote investors.

Securitization let banks take loans and then turn them into securities that could be sold to investors who did not understand the underlying risk as well as local bankers might have. Coupled with loose regulation that allowed banks to issue NINJA loans (loans to folks with no income, no job, and no assets) that were then sold to largely ignorant third-parties who were misled by credit ratings agencies who called these good risks. (Michael Lewis tells this story in the Big Short.)

Financial innovation led to a rapid proliferation of new products that people didn't really understand. Imagine drug development that required no FDA approval or trials and you get some sense of the potential, unknown danger of these new products suddenly in circulation. The derivatives market exploded between 1998 and 2008; notional values grew from $72 trillion to $673 trillion. (If that sounds like a lot, it is. Total global GDP is about $50 trillion.) The market value of derivatives is considerably less than the notional value but even that grew from $2.6 trillion to a stunning $35.3 trillion by December 2008 at the cusp of the Great Recession. What's a derivative? It's a financial instrument whose value is derived from another, like a bet on a stock price or pork bellies. If a name like "financial derivative" makes your eyes glaze over and - at the same time - makes you feel impressed by the fancy term then it is doing its job; it is great to sell a product that is poorly understood but trusted as high-tech. Again, this is another example of risk being shifted from those who understand it to those who don't.

The rapid innovations in finance helped and was helped by the emergence of a shadow banking system. It was negligible in 1980 but by the early 2000s it had grown larger than traditional, regulated banking. In 2007 this shadow banking sector was about $13 trillion.

[Above facts are from Martin Wolf's The Shifts and the Shocks: what we've learned - and have still to learn - from the financial crisis.]

Banks had become public companies rather than private concerns. This gave them more capital to use but it also made them more accepting of risk. If you are a partner in a private bank, you want to make a good return on your money. But this is your money so you also want to avoid a lot of risk. If someone doesn't pay back your loan, you're out that amount. That was the old world. In the new world, banks were public and the money that bankers loaned was stockholders'. Bankers had incentives to originate loans in order to get big bonuses which often were paid at the time of the transaction, not slowly over time as the loan was paid back. Suddenly, the risk was someone else's and bankers wanting a bonus rather than protecting their own capital had an incentive to pursue returns with less discrimination.

Finally, the whole system was more fragile. The push for greater returns coupled with the ability to off-load risk and use someone else's money had driven the market to leverage more. Once upon a time banks had leveraged investments at a rate of 10 or 20 to 1. By 2008, they were leveraging investments at 50 to 1. That sort of leverage greatly inflates your returns on the way up but it disastrously exacerbates losses on the way down.

When the downturn hit - and downturns always hit - the system was fragile and poised for massive losses. The result has already been mentioned (13 million job deficit, $18 trillion in wealth disappeared, etc.)

"The crisis takes a much longer time coming than you think, 

and then it happens much faster than you would have thought."

- Rudiger Dornbusch

We Americans depend on Wall St. and the banks. Finance is to the economy what oxygen is to an ecosystem. The purpose of financial regulation is not to make the game noncompetitive but instead to ensure that competition is about creating value rather than hiding risk, about creating sustainable returns rather than unsustainable bubbles, and protecting the naive from the manipulative. With good financial systems, people still get filthy rich but fewer people go bankrupt. Someone like Elizabeth Warren understands the importance of NFL style regulation. Trump's sensibilities seem to run more towards WWE. That should have frightened voters last week. It should frighten you now.

As to timing of this? I don't know. Glass Steagal was repealed in 1999 and the Great Recession hit within a decade. There is a small chance that Trump and the Republicans have learned the lesson of the Great Recession and won't deregulate. It seems optimistic to assume this. There is a better chance that it takes at least two year for new regulations - or deregulations - to be put in place. And at that point the impact of the return to fragile finance could take a year to manifest or two decades. It's harder to predict than the impact of a rate hike or tax cut.

Why The Country Isn't Ready for President Elizabeth Warren (And Why Culture Matters More Than Policy)

There's a fascinating study on cooperation that has been done around the world. I think it reveals why Elizabeth Warren - a policy maker I love - is not ready to be president. Or, more to the point, why the country is not ready for her to be president.

The study measures cooperation and a sense of the common good. Bostonians demonstrate the highest ranking. Here's how the study (the game?) works.

You and 3 partners start out with $20 each. You can choose to put all, some, or none of your $20 into a central pile. Whatever you put in gets doubled and split between the four of you. So, here are a couple of scenarios.

Everybody Wins:
You start with $20.
You put in $20, they each put in $20, and this $80 gets doubled to $160, which you then split.
You end with $40. (So do they.)
The group gains $80.

You Win:
You start with $20.
You put in nothing, they each put in $20, and this $60 gets doubled to $120, which you then split.
You end up with $50. (They get just $30.)
The group gains $60.

Some Win:
You start with $20.
You put in nothing, two other people put in nothing, and one dupe puts in $20, which gets doubled to $40, which you all split.
You end up with $30. (The dupe gets just $10.)
The group gains $20.

Nobody Wins:
You start with $20.
You put in nothing, the same as everyone else. Your nothing is doubled.
You end up with $20. (So does everyone else.)
The group gains $0.

Now curiously, this game has been played in cities around the world. In some cities, people cooperate to create more wealth. In other cities they don't. The culture changes from place to place.

In Boston, the average contribution per round is close to $20. Massachusetts is one of the richest states (3rd as measured by per capita income) and as befits a region dependent on a highly developed market economy and a mix of public and private sector initiatives, people have developed high degrees of interdependence and trust. Copenhagen is close to Boston on this ranking.

On the other end of the spectrum is Athens. In Greece you're the dupe to put your money into the pot and the culture there suggests that people are trying to avoid becoming the dupe. The average contribution per round in Athens is closer to $6, meaning that game participants create about a third of the wealth. (It seems little wonder that Greece has such trouble with public financing and tax collection.)

The good people of Boston demonstrate the highest levels of cooperation and trust in creating a common good of any city studied. And without that sort of culture, two things are difficult to create: economic progress and, more broadly, a progressive agenda. It's not clear that Elizabeth's policies would seem credible outside of certain areas like Boston, California's Bay Area, Austin, North Carolina's Research Triangle ... essentially places with highly educated work forces working in technologies and industries where cooperation is key. It's one thing to articulate policies that create a common good; it's more difficult to know how to create a culture supportive of such policies. It's easier to know what policy initiatives would help the folks in Boston than it is to know how to change Athen's culture.

There is nothing absolute about the efficacy of policy. Whether particular policy works "depends." A policy rarely works in any condition or culture. Curiously, culture change gets talked to quite a lot within corporations but rarely within nations or neighborhoods. Maybe it's time we changed that.

How To Save a Trillion Dollars

One of my most awkward moments teaching seminars came in an event that included a contingent from a chain of pawn shops. The "finance" company wasn't called a pawn shop, but that is what it was and they had been making a ton of money. When I learned how they operated - a lunch time conversation - I challenged them. This did not go over well and made the next 2 1/2 days awkward. Pawn shops in Florida (and I suppose most states) can essentially charge exorbitant rates to people desperate for money. Even credit card companies cannot charge such high fees. But because they are not banks, pawn shops' interest rates are not regulated like banks.

After the Great Depression, the government regulated banks to make financial markets safer.

After World War II, nonbank corporations found a way around that regulation by offering many of the same products and services as banks. This has proven problematic. Not just to people forced to pawn their goods but to the economy as a whole as the offerings of nonbank corporations has grown to more closely resemble that of commercial and investment banks.

Elizabeth Warren, Obama's expert on consumer finance, a woman who knows her stuff, has written a piece explaining how the Obama administration is passing legislation that will regulate products and services regardless of whether they are offered by banks or nonbanks.

The great news is that the Obama administration appears to be on track on making the reforms that will make it less likely that we'll need bailouts that cost trillions. Financial market regulation has been overlooked for too long. The sad news is that they have to start by solving such seemingly obvious problems.