Never Mind the %

HOW TO CREATE MIDDLE-CLASS JOBS FALL

WINTER / WINTER of ecient markets Advice from the father Plus:

learn from‘racist’ rats What venture capitalists can % Plus: on populist politics funds that earns its fees Raghuram G. Rajan The private-equity fund of NEVER MIND THE % THE MIND NEVER LET’S TALK TALK LET’S THE ABOUT 0.0 should nudge more Why policy makers makers policy Why RESEARCH-DRIVEN INSIGHTS ON BUSINESS, POLICY, AND MARKETS

LET’S TALK ABOUT THE .% WINTER /

The Universityof Chicago Booth School of Business 5807 S. Woodlawn Ave. Chicago, IL 60637 CREDIT-CARD DEBT Page WHY PEOPLE MISMANAGE “It’s almost as if people couldn’t decide whether we had cancer, or maybe a fungal infection. We decided to treat them both, and the problem went away, but maybe that had nothing to do with the treatment.” Page 14 EDITORS’ LETTER

n the book Nudge: Improving Decisions articles and videos about research by CAN WE about Health, Wealth, and Happiness, people who have won—or could yet win— I Chicago Booth’s Richard H. Thaler distinguished prizes such as the Nobel. and Harvard’s Cass R. Sunstein discuss In this issue, you’ll also find comments NUDGE YOU how it’s possible to structure policies from Chicago Booth’s Eugene F. Fama, a and programs in ways that encourage 2013 Nobel laureate, on topics ranging TO READ THIS people to make particular choices, and from corporate governance to algorithmic how governments and organizations trading (page 45). can use nudges to help people make Online, we have a video of Thaler MAGAZINE? better decisions. For example, when giving NFL draft advice, and one of Fama new hires are presented with a company explaining the role of the government in retirement-savings plan, they may the subprime-mortgage meltdown. We receive a form indicating that they will also have both researchers together, in be automatically enrolled unless they an absorbing episode of The Big Question, take steps to opt out, so that the default our monthly video series, in which the option is to participate. two Nobel laureates discuss whether Thaler’s observations (they extend markets are efficient. Fama developed On the cover: well beyond nudging) have transformed the efficient-markets hypothesis, which Average annual behavioral economics, which explores says asset prices fully reflect all available income of top US how human psychology and other information. Thaler’s work has challenged households since nonmathematic factors affect economic this notion. Part of our mission at CBR is 1950. Read more decisions. When Thaler was awarded the to facilitate such conversations between about the “1 percent of the 1 percent” 2017 Nobel Memorial Prize in Economic big economic thinkers. on page 24. Sciences in October, Peter Gärdenfors, a If you’re not already receiving our member of the prize committee, said that email newsletters, sign up on our website, Top 0.01% Thaler has “made economics more human.” and follow us on social media. Through of households Thaler is the eighth Booth faculty research summaries, articles, videos, Top 1% member to win the Nobel Memorial essays, and briefings, we hope to bring (including Prize in Economic Sciences. The prize you information that can help you make the 0.01%) celebrates distinguished work that has decisions that are thoughtful, informed, been completed. But Thaler’s research is and ultimately, better. $40M ongoing—which is why you’ll see a write- up of recent research he coauthored, Hal Weitzman on the cost-benefit analysis of nudges, Executive director, Intellectual Capital $20M explored in this issue (page 7). Editor-in-chief, Chicago Booth Review At CBR, we try to bring you the best [email protected] $0 and latest insights in business research, Emily Lambert 1950 2015 from our faculty and faculty at other Director, Intellectual Capital institutions. We do that in the magazine, Editor, Chicago Booth Review Piketty and Saez, 2016 as well as online, where we have [email protected]

Editor-in-chief Designer Chris Gash Jeff Sciortino Hal Weitzman Nicole Dudka Dee Gill Vanessa Sumo Editor Video editor Howard R. Gold Sebastien Thibault Emily Lambert Elena Guobyte Glen Gyssler Alex Verkhivker Deputy editor Contributors Edmon de Haro Brian Wallheimer Jeff Cockrell Peter Arkle John Kenzie Alice G. Walton Data editor Roger Beale Michael Maiello John Wasik Chuck Burke Boggy Amy Merrick Faculty advisory Social media editor Michael Byers Carl Miller committee Blake Goble Matt Chase David J. Phillips John R. Birge Distribution manager Marty Daks Kyle Platts Lubos Pastor Katheryn Edwards Daniella Deluna The Project Twins Jane L. Risen Copy chief Giorgio Donghi Nicolas Rapp Molly Heim Thomas Finnegan Gregory Reid Multimedia producer Carla Fried Ed Robinson Josh Stunkel Tiago Galo Chana R. Schoenberger Review.ChicagoBooth.edu

Winter 2017/18 Chicago Booth Review 1 CONTENTS DEPARTMENTS

Editors’ letter Feedback The Equation DATAPOINTS COVER STORY Why policy makers Whoops! China’s NEVER MIND THE PERCENT should nudge more stimulus plan boosted Summers: Why you shadow banking Let’s talk about should avoid chasing Companies don’t wait the crowd for legislation to react the 0.01 percent Credit shocks boost to politics By Howard R. Gold economies, but beware Meaningless numbers the fall can boost people’s How health-insurance performance subsidies can help Holier than thou? No, FEATURES patients and hospitals just less evil What Tweets and Yelp Money might inﬂ uence Why we should teach people how to lie reviews are revealing people less than believed In some situations, it’s better to be dishonest To reduce food waste, Do corporate whistle- By Chana R. Schoenberger build more stores blower laws actually The rise of corporate saving Douglas W. Diamond deter fraud? Household saving has declined relative to GDP, but says the next crisis will Why people mismanage companies have picked up the slack be diﬀ erent credit-card debt By Boggy How to save struggling banks: Get tough with high-risk borrowers Trump supporters say they’re optimistic—but they’re not spending

Page 1 7 24 33 Featured Faculty

Richard H. Thaler, Charles R. Eric Zwick, assistant professor Walgreen Distinguished Service of ﬁ nance and James S. Kemper Professor of Behavioral Science and Foundation Faculty Scholar, Economics, won the 2017 Nobel studies the interaction between Memorial Prize in Economic Sciences. public policy and corporate His research is being used to inform behavior, with a focus on public policies worldwide. The day ﬁ scal stimulus, taxation, and he won the Nobel, Thaler taught his housing policy. He is particularly regularly scheduled Chicago Booth interested in the problems faced class on choice architecture, a term by new ventures and small- and originally coined by Thaler and medium-sized private companies. Harvard’s Cass Sunstein. (Page 7) (Page 24)

2 Chicago Booth Review Winter 2017/18 FOOTNOTES Embrace passive management already By Eugene F. Fama What venture capitalists can learn from ‘racist’ rats By Waverly Deutsch With Whole Foods, can Amazon ﬁ ll your every need? By Pradeep K. Chintagunta The real questions the Fed should ask itself By John H. Cochrane What’s the matter with handouts? By John Paul Rollert It’s time to rethink Milton Friedman’s ‘shareholder value’ argument By Asher Schechter, Oliver Hart, and Luigi Zingales The market power of ‘superstar’ companies is growing By Ram Shivakumar Watergate and presidential power in America By Philip B. Kurland What contributed most to the ﬁ nancial crisis? The IGM Panel How can we improve social mobility? The Big Question

40 80

Emma Levine, assistant professor Eugene F. Fama, Robert R. of behavioral science and Charles McCormick Distinguished E. Merrill Faculty Scholar, studies Service Professor of Finance, interpersonal trust and ethical is a 2013 Nobel laureate. He decision-making, especially the is widely recognized as the tension between honesty and “father of modern ﬁ nance,” kindness. To explore the importance having devised the eﬃ cient- of dishonesty in everyday markets hypothesis. He joined communication, she and her the Booth faculty in 1963 and is coauthors asked research subjects to chairman of the school’s Center tell the truth in every interaction for for Research in Security Prices. three full days. (Page 34) (Page 45) FACULTY ILLUSTRATIONS BY JOHN KENZIE KENZIE JOHN BY ILLUSTRATIONS FACULTY CHASE MATT BY ILLUSTRATION COMPASS

Winter 2017/18 Chicago Booth Review 3 Go to Review.ChicagoBooth.edu to ﬁ nd the articles to which these ANOTHER LOOK AT PARTISAN ON COMBATING comments refer. PERFORMANCE CORRUPTION In response to ‘Why are stock returns lower In response to ‘Should we stop the under Republicans?’ (July 2017) “revolving door”?’ (Fall 2017)

WE WELCOME I enjoyed the video based on Chicago Research on the effects of the ‘revolving Booth’s Lubos Pastor and Pietro Veronesi’s door’ is pointless if we ignore the LETTERS research. Their analysis looks specifi cally at the similar effect of pay-to-play, i.e. bribery of our We welcome your comments. US president and his political party. That begs government offi cials in the form of campaign Send email to a question about the other partisan branch of fi nancing, collateral benefi ts accrued by their [email protected] government, Congress. relatives and friends, etc. or send letters addressed to It’s a different story if you include Congress. Transparency (i.e. the opposite of Chicago Booth Review at any of Stock markets during Republican-controlled opacity) is overrated when there is an the following addresses: Congresses outperform Democrat-controlled almost complete absence of enforcement of Congresses by about percent annually. If current laws and regulations and, in cases S. Woodlawn Ave. you look at stock markets when a Republican where there is any enforcement, criminals Chicago, IL president serves with a Republican Congress, get away with a slap on the wrist and that combination outperforms a Democrat taxpayers bear a big portion of the burden Woolgate Exchange president–Democrat Congress by about of the consequences. Basinghall St. percent annually. —Usha Meghani Abramovitz London ECV HA Interestingly, the data show that the Democrat president–Republican Congress combination Level , Cyberport has stock markets that do better than any other Cyberport Rd. combination, at a whopping percent per year THE EFFECTS OF Hong Kong (think Clinton administration). ECONOMIC BOOMS This makes Pastor’s statement in the video, that “stock returns under Democrats have been In response to ‘How China’s stimulus plan about percent higher, on average, than stock inadvertently boosted shadow banking’ JOIN THE returns under Republicans,” a bit too broad in my (Published online, August 2017, and on page opinion. Sure, if you include the word “president” 18 of this issue) CONVERSATION that might be a true statement, but that is leaving To join the conversation, out a pretty important branch of government. follow us on Twitter and LinkedIn, The parallels between the proliferation The US stock market has done amazingly or like our Facebook page. of CDOs [collateral debt obligations] in well for the past years, but I don’t think the late stage of the US housing boom and that’s enough data to make attributions to CORRECTION: The original the rise of “wealth management products” political parties. Bear in mind, Pastor and version of the video “Why are stock following the Chinese infrastructure boom are Veronesi’s research looked at presidents returns lower under Republicans?” remarkable and rather frightening. indicated that the annualized and only nine party changes, and that —Matthew Miller return for the S&P during doesn’t seem like a very large sample. Barack Obama’s administration Rather, I think we have two parties that have was .£ percent, while during shared somewhat equally in the success Ronald Reagan’s administration of this amazing macro bull market. Putting WHAT’S OLD IS NEW partisan bickering aside, Washington is, and it was £. percent. These fi gures In response to ‘When making a profi t was has always been, fi lled with genuinely good are inaccurate. The video has been immoral’ (Summer 2017) updated to refl ect average market people who want what’s best for the country, returns in excess of the three- although they go about it differently. month Treasury bill rate, which It’s a true testament to our amazingly robust Puritans’ moral attitude toward were £. percent under Obama capital markets. Either party can’t help but oversee community/profi ts: in some ways not and £. percent under Reagan. a strong stock market (if you’re optimistic) or screw all that different from the views of millennial Chicago Booth Review apologizes it up (if you’re pessimistic). progressives today. for the error. —Andrew Van Fossen —Ian Salisbury

4 Chicago Booth Review Winter 2017/18 Extra! Extra! Read all about it!*

*it—the latest business, policy, markets, finance, economics, marketing, accounting, and more

Subscribe to the newsletter at Review.ChicagoBooth.edu Insight to go!

Subscribe to the podcast! Listen to every episode of ’s The Big Question series on Apple Podcasts. To reduce food waste, build more stores Page // How to save struggling banks Page Trump supporters are not spending Page // The power of meaningless numbers Page

hen policy makers around the world of rather than into a program, such as a Why policy want to influence their constituents’ retirement-savings plan, might nudge them W behavior, they have a few options. toward participating. So might reducing the They can offer a carrot, such as a tax paperwork necessary to enroll. makers incentive, stipend, or other reward. They Policy makers have seen opportunity can use the legislative stick by passing a in nudging, which is why the United States mandate or a ban. under President Barack Obama had a White should nudge But research suggests they should turn House Social and Behavioral Sciences Team more often to a third tool, a “nudge,” devoted to it, and other governments have more which in many cases is the most cost- analogous teams. To assess whether nudges It can be a cost-effective effective option. are an effective use of public resources, Nudging is the word used in behavioral a group of researchers—University of approach to encouraging science to describe the structuring of policies California at Los Angeles’s Shlomo Benartzi, specific behaviors and programs in ways that encourage, Harvard’s John Beshears and Cass R. but don’t compel, particular choices. Sunstein, University of Pennsylvania’s For instance, requiring people to opt out Katherine L. Milkman, Chicago Booth’s

ILLUSTRATION BY SEBASTIEN THIBAULT Winter 2017/18 Chicago Booth Review 7 Richard H. Thaler, Maya Shankar of Cost-effective solution the White House Offi ce of Science Reviewing a range of incentives employed to and Technology Policy, Will Tucker- get people to put more money toward their Ray and William J. Congdon of retirement plan, research fi nds that a nudge ideas42, and Steven Galing of the US approach is the most cost-effective. Department of Defense—examined the costs and effi cacy of various intervention types. Impact Effectiveness The researchers focused on Average increase Average increase increased behavioral outcomes on in people’s own per $1 spent four priorities identifi ed by the US contributions on the incentive SUMMERS: and UK governments: retirement US dollars savings, college enrollment, energy WHY YOU conservation, and fl u vaccinations. Nudge: Requiring new employees They used existing research into to specify a contribution rate SHOULD specifi c interventions—some undertaken by lawmakers, others by AVOID companies in the private sector—to +$200 +$100 assess the respective costs and results. CHASING In one case, the researchers looked at a nudge by the tax-preparation THE CROWD fi rm H&R Block, which off ered clients assistance in fi ling college fi nancial- Incentive: Offering money to attend “In general, the aid paperwork, and compared that an employee benefits fair right career advice approach with subsidies and tax +$59 +$15 for people is incentives off ered at the state and federal levels. The nudge produced the advice that 1.5 additional college enrollees per made [Richard H. $1,000 spent, making it 40 times more Incentive: Matching 20 percent Thaler’s] career in eff ective than the next most eff ective of contributions many ways. Which intervention the researchers analyzed. is, don’t be like a Likewise, nudging turned out to +$94 +$6 be the most cost-eff ective way of little kid’s soccer encouraging energy conservation. game. In a little One program to nudge consumers into kid’s soccer game, Incentive: Matching 50 percent lower electricity use, sending letters everybody runs to comparing a household’s energy of contributions consumption to that of its neighbors, where the ball is, saved 27 kWh per dollar spent. In and is in the crowd contrast, a rebate off ered by California +$245 +$3 where the ball is. utility companies produced savings If you look at the of only 3.4 kWh per dollar, and other demand-management policies that most successful relied on a combination of consumer research careers, education and monetary incentives Incentive: Changing the tax deduction mostly they’re averaged 14 kWh per dollar. for Danish taxpayers’ contributions to a particular type of pension plan people who The fi ndings suggest that nudges off ered the most impact per dollar stayed where for the other two policy goals as the ball wasn’t. well. “Our selective but systematic Then, eventually, +$540 +$3 calculations indicate that the impact the ball came to of nudges is often greater, on a cost- adjusted basis, than that of traditional their corner and tools,” write the researchers. “In light they were there all of growing evidence of [nudging’s] alone, ready for relative eff ectiveness, we believe that their moment policy makers should nudge more.” Incentive: Higher tax credit of glory.” —Alex Verkhivker for some US taxpayers’ first $2,000 of retirement savings Shlomo Benartzi, John Beshears, Katherine L. ---- F o r m e r U S S e c r e t a r y o f t h e Milkman, Cass R. Sunstein, Richard H. Thaler, Maya Treasury Lawrence H. Summers, Shankar, Will Tucker-Ray, William J. Congdon, and +$12 +$1 speaking at a roundtable discussion Steven Galing, “Should Governments Invest More in hosted by the Becker Friedman Nudging?” Psychological Science, May . Benartzi et al., 2017 Institute in October.

8 Chicago Booth Review Winter 2017/18 Credit shocks boost economies, but beware the fall S President Donald Trump and a Where recession hit harder Republican majority in Congress When the US fell into recession in 1990–91, many of the states that were quicker to roll back U are moving to roll back some of the banking regulations during the ’80s fared worse by these economic measures: banking regulations put in place after the Great Recession. Proponents maintain that Changes in US states’ economies, 1989–92 deregulation would boost the economy by freeing banks to offer credit to more Ranked lowest to highest people and businesses. Sorted by when they rolled back banking regulations during the ’80s: It could work, at least for a while, Earlier Later but there is some recent history that lawmakers might take into account. One Unemployment rate change Change in real GDP Change in of the last major efforts to deregulate Percentage points per capita housing prices banking proved quite successful for some states in the short run, but these same −1 0 +1+2 +3 +4 +5 −10% −5% 0% +5% −20% 0% +20% states were later hurt by the effects of the regulatory easing. Princeton’s Atif Mian, Princeton PhD candidate Emil Verner, and Chicago Booth’s Amir Sufi studied the rollback of banking regulations in the 1980s, when states had the latitude to control the speed of deregulation. Those that moved quickly experienced the greatest benefits as wages and employment rose, GDP expanded, and house prices climbed. But they also later saw the steepest declines in those same metrics when the United States fell into recession in 1990–91. States that rapidly deregulated banking sharply expanded credit availability. More money available to borrow led to increased demand for goods and services, particularly from individuals who bought nontradable goods such as real estate and services. Wages and employment grew in areas such as construction, the service industries, and public services. But the regulatory easing magnified the effects of the 1990–91 recession in early- deregulation states, the researchers find. With household debt high, consumers had to cut back, and they did so in the nontradable sectors that had seen growth. “Credit supply shocks that operate primarily on the demand side of the economy may lead to an amplified business cycle, boosting demand during the expansion but leading to a more severe subsequent contraction,” write the researchers, who also find a link between the rise in a state’s household debt prior to the recession and the severity of the recession in that state.—Brian Wallheimer

Atif Mian, Amir Suﬁ, and Emil Verner, “How Do Credit Note: Research includes Washington, DC, but excludes Delaware and South Dakota, which enacted Supply Shocks Affect the Real Economy? Evidence special laws to lure banks’ credit-card business. Real GDP chart excludes Alaska. from the United States in the s,” Working paper, May . Mian et al., 2017

Winter 2017/18 Chicago Booth Review 9 However, with the ACA HOW HEALTH- in place, people who were previously uninsured said What Tweets INSURANCE they felt healthier, and they reported a lower level of depression—but there and Yelp SUBSIDIES is a lack of data showing actual health benefits. Some reviews are CAN HELP randomized studies have produced clinical health PATIENTS AND measurements, including revealing for blood pressure, blood sugar, and cholesterol levels, HOSPITALS conomists and other social-science but none of these showed researchers are using large bodies of significant improvements. THERE HAS BEEN much text—from Twitter messages, Google debate in the United States The researchers also E searches, Yelp reviews, and other sources— about the costs and benefits review evidence suggesting to predict asset price movements, estimate of publicly subsidized that even modest premiums health insurance. A survey can deter many low-income racial prejudice, and study what’s driving of research on this issue adults from enrolling in consumer decisions. suggests that both recipients health-insurance programs. As text analysis becomes more popular, and nonrecipients, including If premiums were subsidized Stanford’s Matthew Gentzkow and Chicago doctors and hospitals, to ± percent of insurers’ Booth’s Bryan T. Kelly and Matt Taddy average costs, at least benefit from expanding survey the research, and identify and such insurance—but also percent of eligible individuals would elect to stay uninsured explain some of the most common ways to highlights the complicated transform strings of words into usable data. dynamics involved. even if they faced penalties In its simplest form, text analysis involves The impetus for this for doing so. discussion is the If an uninsured patient counting the frequency with which words Affordable Care Act (ACA). were to rack up medical bills, and phrases appear in documents, internet Popularly known as she might walk away from the search queries, or online databases, and Obamacare, the ACA greatly debt, especially if she already using these counts to answer research expanded health-insurance has a low credit score. The questions. (For more, see “Why words costs would ultimately be paid, coverage for low-income are the new numbers,” Spring 2015.) As mostly or entirely, by taxpayers adults by making heavily the fi eld develops, researchers are using and health-care providers. subsidized plans available patterns uncovered by earlier studies to test through federal and state- “Because the uninsured do for potential biases in their own fi ndings. run marketplaces and by not face the full social cost Researchers are also making a host of expanding Medicaid. of being uninsured when According to MIT’s uncompensated care exists, observations—from fi nding political slant Amy Finkelstein, Chicago they have less incentive to in news coverage to measuring how much Booth’s Neale Mahoney, and take up formal insurance political uncertainty aff ects economic Northwestern’s Matthew J. coverage,” the researchers growth. MIT’s Albert Saiz and Wharton’s Notowidigdo, who conducted write. This situation helps Uri Simonsohn use web search results to explain why the ACA levied a review of existing literature, estimate the extent of corruption in US cities. subsidized health-insurance tax-related penalties on people choosing to Seth Stephens-Davidowitz, a former Google coverage can substantially data scientist, uses the frequency of racially reduce the risk that poorer remain uninsured. charged terms in searches to measure patients will have large out- There is an estimated of-pocket expenses. $ billion in overdue US prejudice in areas of the United States. And The subsidized coverage medical debt, according University of Bonn’s Benjamin Born and the also has fi nancial benefi ts to data compiled by the European Central Bank’s Michael Ehrmann for health-care providers, researchers. Many people and Marcel Fratzscher analyze the eff ects of because additional coverage assume that hospitals fi nancial stability reports issued by central pass on unpaid debts from leads to more medical banks. Their research suggests optimistic uninsured patients to charity- spending, and therefore reports move stock markets at least 1 percent based organizations, other revenue, the researchers in the month following their release, while fi nd. Plus the coverage family members, and the pessimistic reports have less infl uence. reduces the implicit costs of government, as well as to Such analyses involve large volumes what otherwise amounts to insured patients by infl ating uncompensated care. The hospital charges. But the of data. “A sample of 30-word Twitter uninsured “pay only a small researchers fi nd limited messages that use only the 1,000 most fraction of their health-care evidence of a hospital’s common words in the English language costs, on the order of one- ability to “cost-shift.” has roughly as many dimensions as there fi fth to one-third of their —David J. Phillips Subsidized coverage are atoms in the universe,” write Gentzkow, medical expenditures,” write reduces the cost Amy Finkelstein, Neale Mahoney, and Kelly, and Taddy.—Amy Merrick Finkelstein, Mahoney, and Matthew J. Notowidigdo, “What Does of what otherwise Notowidigdo. Providers and (Formal) Health Insurance Do, and for amounts to Go to Review.ChicagoBooth.edu to see citations for other parties pay the rest. Whom?” Working paper, June . uncompensated care. research in this article.

10 Chicago Booth Review Winter 2017/18 Deconstruct swaths of text into useful data sets Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod tincidunt ut laoreet dolore magna aliquam erat volutpat. Ut wisi

Writings, transcripts, conversations, social media, etc. Good night, good night! Parting is such sweet sorrow, . Step 1 That I shall say good night Remove punctuation till it be morrow A process of deconstruction While researchers have been processing text into numeric data for decades, new technologies are enabling them to analyze these data in inventive ways. This Shakespearean sample gives an overview of what researchers are doing on a large scale, preparing text ― for different kinds of analysis. Step 2 Remove Replace words Remove with their roots punctuation common words, also known as “stop words” p good night, good night! arting is such sweet sorrow, Remove common Make a “bag of words”: words, also known Disregard the order and as “stop words” . count how many times that I shall say good nighteach word appears

METHODS RESEARCHERS USE Step 3TO ANALYZE TEXT DATA till it be morrow Dictionary-based Generative model: “Stemming”: methods: After Word Count Here researchers Replace words making a bag of explicitly simulate words, researchers good 3 the process by with their root classify them which language according to a ―Step 4 is produced. For predeﬁ ned dictionary I 1 example, when more such as Harvard’s Make a people lose their General Inquirer program, which groups jobs, unemployment-related terms will rise them by sentiments such as “positive” or “bagmorrow of words”: 1 in web searches. One common generative “optimistic.” “This is by far the most common model is a topic model, which discovers the method in the social science literature using Disregardnight the order, 3 themes in a collection of documents and text to date,” the researchers note. and count how then clusters the documents accordingly. manypart times each1 Text regression Deep-learning model: This type wordsay appears. 1 techniques: of model uses Artiﬁ cial neural statistical methods networks simulate to predict some shall 1 interconnected attribute, such as brain cells inside real-estate prices, Wordsorrow Count 1 a computer. They from counts of recognize nonlinear words. The most common text regression relationships in complex data sets extremely How researchers analyze text data model, known as a penalized linear model, sweet 1 well. New “deep” versions of neural networks imposes constraints that minimize irrelevant good 3 work faster with less tuning required by users. estimates. This approach does not try to till 1 Already powering Google Translate, these model the structure of the language. I 1 methods are catching on quickly in research.

Thank you for Thank youGentzkow for et al., 2017 checking in. I’m checking in. I’m morrow 1 traveling today and traveling today and Winter 2017/18 Chicago Booth Review 11 tomorrow -- my tomorrow -- my night 3 husband’s elderly husband’s elderly part 1 grandparents are not grandparents are not doing very well, so we doing very well, so we say 1 made a trip to made a trip to shall 1 Philadelphia to see Philadelphia to see them. I’ll be flying back to Chicago tomorrow them. I’ll be flying back to Chicago tomorrow sorrow 1 evening, so I don’t think I can finish the draft evening, so I don’t think I can finish the draft sweet 1 in time for the Wednesday morning art in time for the Wednesday morning art till 1 Much of the guidance is targeted at consumers. The UN, for example, advises To reduce people to plan meals, eat the food already in their fridges before buying more, and food waste, compost food scraps. But research by Chicago Booth’s Elena Belavina suggests policy makers should focus less on consumer build more advice and more on urban planning. Her research fi nds that many cities could stores signifi cantly reduce food waste by increasing grocery store density. ore than one-third of all food Belavina looked at the number of stores produced in the world is wasted, in a given market area and built a model M according to the United Nations. that weighs the eff ects of store density on In industrialized countries, retailers consumers and retailers. On the consumer and consumers throw out 300 million side, higher store density leads to lower metric tons of perfectly fi ne food per consumer food waste, she fi nds. When stores year—enough to feed the estimated 900 are closer to each other, they’re also closer million people who are going hungry. and more accessible to shoppers, which The UN, United States, and European means people go shopping more often and Union have set a goal to halve food buy less on each visit. waste by 2030, and to meet that, some When the store is convenient, a shopper countries including the US are running is less likely to stock up—and less likely to let public-service or education campaigns to food spoil. “Households have to travel less encourage people to waste less food. to visit a store in denser markets, which incents more frequent trips to grocery stores and smaller basket sizes or household inventory levels,” Belavina writes. “Smaller involves more centralized inventory. Demand inventory levels imply less food waste as it is also more irregular and variable, Belavina is less likely that the inventory will expire says, as shoppers who stock up return to before it is consumed.” stores on a more predictable basis than However, higher store density also leads to shoppers with less in their baskets. The end more retail food waste. When customers waste result: stores end up with leftover inventory, less, they buy less. Meanwhile, each store which becomes waste. serves a smaller area and carries inventory, Belavina created a model that weighs which is less effi cient than a system that the competing eff ects and countereff ects.

Ideal balance of grocery stores and food waste Research suggests how many stores could be added in ﬁ ve US locations to generate the lowest level of waste. Optimal density of grocery stores Annual per capita carbon emissions associated with food waste, by number of stores Actual stores per 10 sq km Optimal number

Denver Los Angeles Chicago Ithaca, New York Manhattan Population densities Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions People per 10 sq km

5 stores Los Angeles Chicago Manhattan 28,360 44,470 (New York City) 400 400 400 400 400 241,370 11.25 stores 15 stores 54.25 stores 300 300 300 300 300 102.5 115 147.5 195 200 200 200 200 200 458 495 stores

100 100 100 100 100 Denver Ithaca, 15,500 New York 0 0 0 0 0 19,000 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500

Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km PLATTSKYLE BY ILLUSTRATION Stores per 10 sq km Stores per 10 sq km Belavina, 2017

12 Chicago Booth Review Winter 2017/18 Optimal density of grocery stores Consider, for example, that when there Annual per capita carbon emissions associated with food waste, by number of stores Actual stores per 10 sq km Optimal number are more stores in an area, there’s more Denver Los Angeles Chicago Ithaca, New York Manhattan Population densities competition, which leads to lower prices. Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions Measure of carbon emissions People per 10 sq km 5 stores Los Angeles Chicago Manhattan “This increases consumer waste as 28,360 44,470 (New York City) 400 400 400 400 400 241,370 consumers waste more of the cheaper 11.25 stores 15 stores 54.25 stores 300 300 300 300 300 groceries,” she writes. “This higher 102.5 115 147.5 195 consumer waste translates into higher 200 200 200 200 200 458 495 market demand, which decreases retail waste stores 100 100 100 100 100 on account of the smaller safety stocks.” Denver Ithaca, 15,500 New York Belavina’s analysis reveals that despite this, 0 0 0 0 0 19,000 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 and despite generally increased retail waste, Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Belavina, 2017 higher store density does generally reduce food waste. She looked at Chicago, Denver, Los Angeles, the borough of Manhattan, and Ithaca, New York. In Chicago, having just three to four more stores per 10 sq km would lead to 6–9 percent less food waste. “Recall that the carbon footprint of food waste is comparable to that of all road transportation,” she writes, “thus these gains are very substantial.” The eﬀ ects were less pronounced for Manhattan, where the stores are already closer together. But more density reduces waste only up to a point. When stores reach a threshold density, there’s more food waste. None of the cities she looked at have yet reached that point, although Manhattan is closest. The optimal density of stores there would be 495 stores per 10 sq km, she calculates, whereas the actual density is 458. “Adding signiﬁ cantly more stores here might even lead to an increase in waste.”—Ed Robinson

Elena Belavina, “The Structure of Grocery Retail Markets and Food Waste,” Working paper, August .

Optimal density of grocery stores Annual per capita carbon emissions associated with food waste, by number of stores Actual stores per 10 sq km Optimal number

100 100 100 100 100 Denver Ithaca, 15,500 New York 0 0 0 0 0 19,000 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Stores per 10 sq km Belavina, 2017

Winter 2017/18 Chicago Booth Review 13 OUR SEASONALLY 4 ADJUSTED Q&A

Douglas W. Diamond says the next crisis will be dierent Merton H. Miller Distinguished Service Professor of Finance, Chicago Booth

It has been 10 years since the 2007–10 financial crisis started. What have we learned about what happened? There are several narratives, but no consensus on the “reason” for the crisis. One narrative is that the system was too interconnected—too many people relied on other people who bought insurance, credit default swaps, and so on. Another narrative says people panicked, and there was a run on the financial system that had to do with short-term debt. A third narrative is too big to fail (TBTF). TBTF is a problem, but it wasn’t the reason the crisis occurred. Who caused the most trouble? Investment banks such as Lehman Brothers. I don’t think anyone thought Lehman was too big to fail. The things at the center were not the traditional TBTF institutions. I gave a speech before 2007 saying financial crises are everywhere and always caused by problems related to short-term debt. It looks to me like what happened was a run.

What do you think of the postcrisis regulations? There’s no great evidence yet about whether Dodd-Frank has been good or bad. Probably more than 40

14 Chicago Booth Review SeasonWinter 2017/182016 PHOTO BY JEFF SCIORTINO percent of the bill is good, and nothing The banks that saw a is a disaster. But we haven’t had another HOW TO SAVE significant rebound in their big financial crisis, so we can’t say which return on assets in the following of the hundreds of requirements in it STRUGGLING three years were “significantly were good, unnecessary, or bad. more aggressive in managing their riskiest clients” than the The big banks don’t like the BANKS: banks that didn’t recover— capital requirements or the Volcker GET TOUGH “managing” here meaning they Rule, which says you can’t do this raised their lending standards to (proprietary trading) and that WITH HIGH-RISK reduce default exposure. (lending). I like capital requirements Some banks cut off credit to better than the Volcker Rule, because troubled borrowers, whereas a lot of things look like proprietary BORROWERS others extended additional loans, hoping to see a client through trading, including market making. The IN A PERFECT WORLD, all Volcker Rule seems to have cut the banks would be able to a crisis to a turnaround. The amount of bonds that market makers withstand the punch of a research suggests the former approach is more successful. hold, and there’s controversy about severe economic downturn Zeroing in on the banks’ whether the bond market has become that causes loan performance to degrade and profits to riskiest corporate borrowers less liquid. with the highest probability of When you don’t know what caused shrivel. But as recently as the 2007–10 financial defaulting, the research pushes the crisis, it’s hard to write a law to treat crisis, robust central-bank back against the notion that it. It’s almost as if people couldn’t decide intervention was needed always continuing to provide whether we had cancer, or maybe a to shore up distressed more credit will pay off for the fungal infection. We tried to treat them banking systems. lender. The banks that did both, and the problem went away, but Subsequent policy shifts, not get a substantial profit recovery reduced their lending maybe that going away had nothing to such as increases in capital to their clients deemed at the do with the treatment. Maybe it went requirements, and ongoing highest risk of defaulting by away on its own. stress testing may help reduce the number of banks that fail just £ percentage points a year. because of economic shocks. The banks that managed to Are we any safer than we But these policies are unlikely work their way back were more were in 2007? to eliminate the problem of abstemious with their high-risk 3 Yes, I think Dodd-Frank did banks in distress. This raises a corporate borrowers, cutting make things safer, although we’d be safer question: When a bank suffers those loan portfolios by even if we hadn’t passed any laws at all. a deep downturn, is there any percentage points a year in the We don’t tend to have two crises in a row. way to gauge its likelihood three years following the banks’ profit shock. Memories are still fresh. People say, “I of recovering? In another pass at the made that mistake yesterday. I’ll make a Emilia Bonaccorsi di Patti of the Bank of Italy and Chicago data, the researchers omitted different one today.” the three largest banks in Dodd-Frank didn’t outlaw every risky Booth’s Anil K Kashyap find a potential “idiosyncratic” factor the study to see if the banks’ practice that could cause a crisis. No law correlated to the bouncing large footprint was skewing could or should. Something’s going to back of distressed banks. results, but this only amplified happen, and at that point, we’ll see how Setting aside the issue of the finding. In this subset, well it works. liquidity—or depositor runs, nonrecovering banks didn’t But one stated intent, I think, in which often precipitate seizure adjust their credit lending to high-risk customers, while the writing the law was to make sure there by banking regulators—the recovering banks cut credit to would be no bailouts ever again. And researchers focus their analysis on loan quality. those firms by an average of if that’s how the law were to ever percentage points per year. actually be interpreted, that would be “Recovery depends primarily on post-shock adjustments The research findings a huge problem. The ability to prop made by the banks, particularly could help regulators measure up the financial system in a crisis is to their loan portfolios,” the the potential outcomes of essential. That’s what central banks and researchers write. intervention. “Regulators tend governments are about. We don’t want Di Patti and Kashyap followed to disclose relatively little about to rely on their help too much, but we the fortunes of Italian what steps are taken with don’t want to make that help impossible. banks that took a severe blow to respect to banks that require profitability in the mid-±±s, intervention. Our findings a period when the country suggest paying close attention You’ve studied banking for to whether the distressed banks more than 40 years. Will we experienced a deep recession 4 during which more than ± are being particularly vigilant have another crisis? percent of bank loans were in containing credit to high risk We will have another crisis. We’re not —Carla Fried nonperforming and the loan borrowers.” going to get rid of them, but we can default rate more than doubled certainly cut down on the severity of Emilia Bonaccorsi di Patti and Anil K to a high of £ percent. They then Kashyap, “Which Banks Recover from them. But you’re not going to get crises monitored how the banks fared as Large Adverse Effects?” Working paper, down to zero. the economy recovered. August .

Winter 2017/18 Chicago Booth Review 15 D 16 spending not they’re they’re optimistic—but say supporters Trump party, Trump supporters have not let optimism from voters in the victorious is accompanied by a jolt of economic supporters of the oppositiondo. party the economy is in better shape than in the party White House think typically have demonstrated, supporters of the As decades of researchpolitical-science commonplace among the US electorate. economic perceptions that has become president, playing out a splitpartisan over Winter 2017/18 Chicago Booth Review Winter But though each presidential election the economy after he was elected significantly more optimistic about onald Trump supporters became Mian, Sufi, and Khoshkhou started before election, according to the findings. such behavior in the aftermath of the spending, Trump voters didn’t display economic expectations will boost their predict that consumers with optimistic Services. Although economists generally of Argus Information and Advisory Booth’s Amir Sufi, and Nasim Khoshkhou research by Princeton’s Atif Mian, Chicago US presidential elections, according to supporters of winners in the four previous spending habits, and neither did the their newfound confidence affect their The research is an extension of work a spending bump. card spending. They find little evidence of such as new-car registrations and credit- well as county-level data reflective of sales surveys and polls of individual voters, as They looked at data sources including spending patterns on a level.countywide habits of voters, analyzing optimism and looked again at the opinions and consumer didn’t change. to purchase less, but their spending actual generally opposed him said they planned Obama’s 2008 election, voters in areas that didn’t necessarily match up. After Barack driven consumer sentiment and spending 2000 and 2012, they find that election- results for presidential elections between Winter 2015.) Analyzing county-by-county elections don’t drive consumer spending,” into spending. (For more, see “Relax, US elections doesn’t necessarily translate that optimism inspired by political Trump’s election, in which they uncover After Trump’s election, the researchers

ILLUSTRATION BY CHRIS GASH The cumulative results indicate The state of the economy is partisan that over the past 20 years, the While Republicans’ and Democrats’ optimism about the US economy shifts depending on partisan eff ect has grown increasingly whether they hold the presidency, the gap between the parties’ opinions has been widening. strong, widening the gap in economic expectations between the winning and Difference between Republicans’ losing camps. Trump’s election led to and Democrats’ sentiments about the US economy an unprecedented relative increase in optimism, eight to nine times larger Standard deviations George W. Bush than the election of George W. Bush in Second term 2000, and three to four times larger than the eff ect following Obama’s 0.37 elections in 2008 and 2012. The researchers fi nd support for the notion that the expectations gap created by electoral results is the product of Barack Obama partisanship rather than other factors, First term such as policies that benefi t one party’s voters more than the other’s. Looking 0.71 at state- and county-level data, the authors fi nd there’s little to suggest that “economic circumstances change to the benefi t of areas supporting the new president after elections.” In fact, even Barack Obama Democrats and Republicans within the Second term same zip code have profoundly diff erent outlooks on the future of the economy. 0.89 Despite Trump supporters’ upbeat expectations, as was the case following earlier elections, optimism doesn’t appear to have translated Donald Trump into spending. Though Republican Through June 2017 respondents to a Gallup survey question did report a 6 percent 1.11 increase in spending after the election, Republicans polled by the University of Michigan didn’t feel it’s a better time to buy durable goods, such as appliances, Republican counties’ spending when their candidate won . . . electronics, or furniture. Data on Change in auto sales for every 1 percentage point advantage in county vote actual (as opposed to reported) Baseline: October, just before each election spending also don’t refl ect an increase: as of June 2017, the counties that voted +0.1% Bush heavily in favor of Trump had seen no 2000–01 increase in car buying. This extends −0.1% the pattern the researchers identifi ed Bush before the election, but “the evidence −0.3% 2004–05 for the 2016 election is most striking,” Trump they write. −0.5% 2016–17 For economists, the fi ndings call into JulJun Aug OctSep Nov JanDec Feb AprMar May question the practical interpretations of economic expectations. When . . . and when their candidate lost researchers ask a consumer how healthy she expects the economy to be +0.3% fi ve years out, they typically treat the answer as a refl ection of the individual’s +0.1% expectations about her own potential income, and therefore spending power. −0.1% Obama But this study suggests postelection 2008–09 optimism doesn’t necessarily lead to −0.3% Obama economy-boosting spending.—Dee Gill 2012–13 JulJun Aug OctSep Nov JanDec Feb AprMar May Atif Mian, Amir Sufi , and Nasim Khoshkhou, “Partisan Bias, Economic Expectations, and Household

PHOTOS BY US DEPARTMENT OF DEFENSE; US DEPARTMENT OF STATE (OBAMA ) (OBAMA STATE OF DEPARTMENT US DEFENSE; OF DEPARTMENT US BY PHOTOS Mian et al., 2017 Spending,” Working paper, July .

Winter 2017/18 Chicago Booth Review 17 Local governments’ debt balance Municipal corporate bonds issued, as a percentage of China’s GDP loansOther indebts 2009, there was, from 2012 to 2016, moreBank loansgrowth in municipal corporateOther purposes bonds Whoops! China’s stimulus plan Municipal corporate bonds Investments Munibonds Bank loan repayments andTrusts shadow-banking and entrusted loans activities. 3% boosted shadow banking TrillionsLocal-government of RMB Trillions of USD nonbank (2017) debt, as a

fraction¥30 of China’s shadow-banking$4.5 balance, 2.5%

ominique Strauss-Kahn struck an To track shadow-banking activity, Chen, grew¥25 from a negligible 1.5$3.75 percent in 2008 Stimulus 2% optimistic note in response to He, and Liu looked at municipal corporate to 22 percentyear in 2014 and 48 percentStimulus ¥20 $3 year the State Council of China’s 2009 bonds (or cheng tou zhai in Chinese), one in 2016, write Chen, He, and Liu. Local 1.5% D ¥15 $2.25 announcement of an unprecedented form of nonbank fi nancing that many local governments especially turned to this type 1% 4 trillion RMB fi scal-stimulus package, governments took on. Local governments of¥10 fi nancing after 2012, $1.5when bank debt 0.5% in the wake of global fi nancial recession. issue these bonds to fi nance infrastructure came¥5 due. As many economists$0.75 believe Strauss-Kahn, managing director of the projects whose benefi ts and revenue streams that¥0 Chinese governments$0 will continue 0% ’16’14’12’10’08 ’16’14’12’10’08

International Monetary Fund at the materialize several decades later. As most toNote: fi 2013–16nance bank loan their data are approximate. debts through shadowChen et al., 2017; XE Currency Converter time, said the stimulu s would “have an such bonds are invested by households banking, it’s clear that stimulating China’s infl uence not only on the world economy via wealth management products, the economy has come with a signifi cant cost. in supporting demand but also a lot of shift toward nonbank debt across China —Alex Verkhivker infl uence on the Chinese economy strongly paralleled a rise in China’s shadow- Zhuo Chen, Zhiguo He, and Chun Liu, “The Financing of itself, and I think it is good news for banking sector. In provinces where local Local Government in China: Stimulus Loan Wanes and correcting imbalances.” governments took out more-stimulus-related Shadow Banking Waxes,” Working paper, July . But less than a decade later, China’s local governments are struggling under massive The rise of nonbank loans debt caused by the stimulus, research China’s ± stimulus allowed local governments to take out bank loans, but when it came suggests. Tsinghua University’s Zhuo Chen time to repay them, the country saw a rise in nonbank fi nancing. and Chun Liu along with Chicago Booth’s Zhiguo He document how the stimulus Local governments’ debt balance Municipal corporate bonds issued, led to rising debt and a surge across China as a percentage of China’s GDP Other debts in shadow-banking activities—lending and Bank loans fi nancial activities conducted by institutions Other purposes Municipal corporate bonds not regulated as banks. Investments Munibonds Bank loan repayments Basing their analysis on various public Trusts and entrusted loans and nonpublic data sources, Chen, He, 3% and Liu estimate that the stimulus took the Trillions of RMB Trillions of USD (2017) form of around 5 trillion RMB in bank loans that were pushed to the Chinese economy ¥30 $4.5 2.5% in 2009 alone. Meanwhile, the total debt balance of Chinese local governments ¥25 $3.75 ballooned from 6 trillion RMB in 2008 to 27 Stimulus 2% trillion RMB in 2016, with most of that debt year Stimulus ¥20 $3 year coming from nonbank loans. 1.5% According to the researchers, this dramatic growth in nonbank, local- ¥15 $2.25 government debt is a manifestation of 1% the 2009 stimulus plan’s overhang eff ect. ¥10 $1.5 Local governments took out bank loans in 0.5% 2009, but they had to repay all those loans ¥5 $0.75 around three to fi ve years later, at which point the governments resorted to nonbank ¥0 $0 0% fi nancing to either continue their long-term ’16’14’12’10’08 ’16’14’12’10’08 infrastructure projects or roll over their maturing bank loans. Note: 2013–16 bank loan data are approximate. Chen et al., 2017; XE Currency Converter

KEY INSIGHT COMPANIES DON’T WAIT FOR LEGISLATION TO REACT TO POLITICS When legislators debate tax policy, corporate managers listen, according to research from Stanford’s Lisa De Simone and Joseph D. Piotroski and Chicago Booth’s Rimmy Tomy. Between 2009 and 2011, when US policy makers considered numerous bills offering a repatriation tax holiday to companies holding cash abroad, the companies most likely to repatriate “accumulated $376 billion to $488 billion in excess cash in anticipation of a reduction in repatriation taxes,” the researchers ﬁ nd. Lisa De Simone, Joseph D. Piotroski, and Rimmy Tomy, “Repatriation Taxes and Foreign Cash Holdings: The Impact of Anticipated Tax Policy,” Working paper, May 2017.

18 Chicago Booth Review Winter 2017/18 udges, behavioral-fi nance parlance for little cues that urge us to do things at N certain times, have been embraced by governments and organizations to infl uence behavior. For example, when you pay a Study participantsparticipants saw a display with a point score while they peperformedrformed restaurant bill with a credit card, a list of a task such as exercising on gym suggested tip amounts can nudge you into equipment or filling out online tipping at least 15 percent. When you sign up for sursurveys.veys. The group that saw their a retirement plan, the company may precheck a scores rise at an accelerating pace box to nudge you into participating. peperformedrformed significantly better.better. Now research suggests people may respond as well to “numerical nudges,” which are dynamic ParticipantsParticipants sawsaw their scores rise and changing but inherently meaningless at one of ttwowo paces Odd, arbitraarbitraryry point scalescale numbers that can nevertheless be used to strategically alter behaviors. Luxi Shen of the Chinese University of Hong Decelerating AcceleratingAccelerating Climbs quicklquicklyy Slower at first,first, Kong (a recent graduate of Chicago Booth’s PhD at first, thethenn then climbs Program) and Booth’s Christopher K. Hsee ran slows dowdownn more rapidlyrapidly several experiments designed to test numerical nudges. In one, the researchers had people complete online surveys rating advertisements, 1,461 telling participants that the three people who 1,4111,411 fi nished the most surveys would receive a cash 1,361 prize. For every survey completed, participants received a score, which did not indicate anything 1,3111,311 about a person’s performance and could not 1,2611,261 be exchanged for any reward. But participants responded to the scores anyway. People who 1,2111,211 saw their point total accelerate quickly fi lled out 1,1611,161 signifi cantly more surveys. 1,1111,111 Another experiment tested men who were doing two-minute rounds on a step machine. Such machines typically track the number of 0 10 20 30 40 50 steps a person takes while exercising, but the Units of efforteffort researchers adjusted some machines to display an extra number that increased according to Number of susurveysrveys completedcompleted a preprogrammed algorithm. “Notably, this number carries no independent information,” ToTotaltal the researchers write—and they told the men as much. Yet once again, participants who saw 0 10 20 30 40 50 their “X number” scores accelerate more quickly climbed more steps than others. How the two groups perperformedformed A variety of organizations could use numerical when askaskeded to exerciseexercise as hard nudging to infl uence behavior, the researchers as possible on a step machine Units of effoeffortrt (1 = 8 steps) say. For example, retailers could give shoppers a score for repeatedly buying the same product. FirsFirstt If a person sees the score climb quickly after he round purchases a specifi c brand of soap, for example, he may buy even more of it on his next shopping Second trip. An accelerating number, says Shen, could be used to motivate people to pay bills on time, save Third energy, and more.—John Wasik FoFourthurth Luxi Shen and Christopher K. Hsee, “Numerical Nudging: 0 10 20 30 40 50 Using an Accelerating Score to Enhance Performance,” Psychological Science, June 2017. Shen and Hsee, 2017

ILLUSTRATION BY GIORGIO DONGHI GIORGIO BY ILLUSTRATION

Winter 2017/18 Chicago Booth Review 19 MONEY MIGHT INFLUENCE PEOPLE LESS THAN BELIEVED THINKING OF MONEY can change how people think, feel, and behave—or, at least, this has been generally accepted among behavioral scientists for the past decade. But research by Chicago Booth’s Eugene M. Caruso, Stony Brook University’s Oren Shapira, and Booth postdoctoral scholar Justin Landy raises questions, and suggests that these systematic effects on thinking and behavior may be overstated, if they exist at all. Other experiments revealed the same Numerous published studies Holier than thou? “asymmetric self-righteousness,” as the have found that thinking about researchers call it: people consistently money makes people feel more self- No, just less evil reported they were less evil but no more sufficient. The first such one, from moral than others. In one case, participants , involved things that remind people of money, or “money primes.” ocial psychologists have documented that predicted that they’d feel worse after carrying More than experiments generally people believe they’re more likely than out a selfish act (giving away just $1 of $6), but supporting the theory were published Sothers to donate blood, give to charity, not any better than others after carrying out an in the subsequent decade. treat another person fairly, or give up their unselfish act (giving away $5 of $6). In another But when Caruso, Shapira, and seat on a crowded bus for a pregnant woman. case, participants believed they’d give more Landy were conducting their own, But research from University of Chicago money to another person than others would in related experiments, they found postdoctoral researcher Nadav Klein and their most selfish moment—but no more than that demographic characteristics Chicago Booth’s Nicholas Epley suggests that others in their most generous moment. sometimes appeared to influence the people don’t necessarily believe they are holier And people felt they were less likely than results, and they realized that other than others. Instead, people simply believe they others to engage in immoral behaviors, such research had also produced similar inconsistencies. are less evil than others. Understanding the fine as stealing a $20 tip left for a waiter—but To probe these inconsistencies, distinction between the two ideas could be used neither more nor less likely to engage in moral the researchers systematically to help guide behavior. behaviors such as returning a lost wallet. evaluated the effects of previously The researchers conducted a series of When it comes to ethical behaviors, used money primes, testing a number experiments to explore how people think of people judge themselves based on their own of the prompts across a diverse their own and others’ virtue. In one, Klein and positive intentions, but they judge others sample of people. They first had Epley called people into a lab and told some based on their actions, the researchers write. , online participants view one participants (“targets”) that they would be And when it comes to unethical behaviors, of several prompts. One group saw paired up with other participants (“actors”). people justify their own actions but are less the instructions for the study over a Each pair had a chance of winning $10 at the understanding of others’. faded image of a stack of bills. Others were asked to imagine being wealthy end of the experiment, but the actors got to The findings could benefit people writing or impoverished in the future, or to decide how this $10 would be split between policies that try to encourage particular unscramble money-related phrases. themselves and the targets. behaviors. Take, for example, a company Almost all of the manipulations Klein and Epley instructed some actors either that wants to initiate policies that promote did get participants thinking to keep $9 out of the $10 for themselves (a selfish ethical practices, such as avoiding gender about money. But the primes had action) or to keep only $1 (a generous action). bias in job applications. If people believe weak and inconsistent effects The researchers then asked all participants they are unlikely to engage in unethical on whether these thoughts led whether the actors would have done the same behaviors, saying these policies are aimed participants to feel wealthy or thing had they been free to do so. at preventing unethical behavior might be self-sufficient. And demographics including gender, socioeconomic The actors who were told to selfishly keep ineffective “since in that case people might status, and political ideology $9 were self-righteous—they were less likely think, ‘Oh, that doesn’t apply to me!’” says produced no clear patterns. than the targets to believe that this selfish Klein. “So the better way to frame these The results raise questions about action represented their true character. policies may be as ones aiming to promote priming. Beyond that, they produce However, the actors told to keep only $1 were ethical—rather than discourage unethical— a method that could be used to no more likely than targets to believe that behavior.”—Alice G. Walton test other findings in psychological this generous action represented their true research.—Alice G. Walton character. Actors saw themselves as less evil Nadav Klein and Nicholas Epley, “Less Evil than You: Bounded Self-Righteousness in Character Inferences, Go to Review.ChicagoBooth.edu to see than targets thought them to be—but they Emotional Reactions, and Behavioral Extremes,” Personality citations for research mentioned and to read didn’t see themselves as more ethical. and Social Psychology Bulletin, June . a longer version of this article.

20 Chicago Booth Review Winter 2017/18 ILLUSTRATION BY TIAGO GALO whistle- H Do corporate corporate Do of accounting fraud, Lee used two whistle-blower program.) companies that are subject to the Securities effectiveness of federal programs, she of accounting fraud by 7 percent. The effects of the Sarbanes-Oxley Act of 2002 enforcement actions. (Lee did not consider which offer tipsters financial rewards (and tam and Exchange (SEC) Commission whistle- associated with fraud. analyzed companies, during a sample amount, Lee reports. (To gauge the and obtain a portion of any money a recent graduate of Chicago Booth’s PhD according to the of dissertation Heemin Lee, a shield from employer retaliation) for part part of the Dodd-Frank Act—which allows prediction models that identify unusually period of 2008–14, that had not been retaliation along with financial rewards recovered. The other was composed of One was made up of those subject to state- subsequently exposed to the SEC’s subject to state-level FCAs but were strengthen “whistle-blower” incentives, blower laws laws blower FCAs reduced a company’s probability Program, now at CUNY-Baruch College. the probability of fraud by a similar threat of whistle-blowing under state to file a lawsuit on behalf of the government individuals to provide tips directly to the inventory, and other conditions often if the information leads to successful high accruals, high inflatedaccruals, sales, overstated level False Claims Acts (FCAs) that have a actually SEC and offers enhanced protection from SEC whistle-blower program reduced blower program—implemented in 2011 as a bounties to whistle-blowers.) because the does act not provide financial blowing the lid on corporate fraud. deter fraud? deter To determine the change in probability These These initiatives helpcan deter fraud, Her data suggest that exposure to the Lee Lee examined two classes of companies. provision, which allows a private citizen recent years spurred state and igh-profile financial frauds in federal authorities to implement or qui qui company variations in state-pension-fund an FCA with a noted by audit firms: their fees tended to reduced potential auditor liability. financial financial rewards by reporting financial US public-equity US holdings public-equity of state pension state’s pension fund. Lee then used within- to state FCAs, Lee finds. When there’s a fall by 5 percent after clients were exposed funds in that jurisdictions had enacted fraud of any company, regardless of its lower probability of fraud, there’s also location, location, whose shares were owned by the blowers in these states could obtain The deterrent effect could have been Lee Lee constructed her first sample using qui tam provision. Whistle- Winter 2017/18 Chicago Booth ReviewWinter companies companies subject to the SEC whistle- whistle-blower provision.— exposed to state FCAs tended to have a ownership as well as variations in state group consisted of companies that were more marked response to the new federal previously exposed to state FCA provisions. Accounting Fraud?” Working paper, October . Companies Companies that had not previously been scope of coverage, to identify companies FCAs, such as the year of passage and the to some degree. that were subject to whistle-blowing laws Heemin Lee, “Does the Threat of Whistleblowing Reduce blower program. Here, Lee’s control The second sample consisted of Marty Daks Marty 21 Why people mismanage credit-card debt

onsumer-finance experts usually advise people with balances on multiple credit cards to make the minimum payments on all of their cards So what were they thinking? The researchers explored five scenarios: and then put any remaining payments on the card with the highest interest rate. However, relatively few people do that, and research suggests why. According to University of Nottingham’s John Gathergood and Jörg Weber, Chicago Booth’s Neale Mahoney, and University of Warwick’s Neil Stewart, consumers try to manage multiple debts at once rather than pay off the most expensive one. That flawed approach can be costly. The researchers consider a number of explanations, including that people could be repaying the credit card with the highest capacity, € the highest balance, or the lowest balance. Looking at a data set based on records from five major credit-card issuers in the United Kingdom, they pit these explanations against their own theory, “balance matching,” in which payments are proportionate to overall amounts owed.—CB €

People didn’t follow the most cost-effective path The researchers assessed the credit-card records in their data set and conﬁrmed that the experts’ advice was on point. After taking care of BALANCE MATCHING AVOIDING MAX-OUT MAKING ROOM BIGGEST BALANCES SMALL VICTORY monthly minimum payments: Making payments Prioritizing the card Prioritizing the card Prioritizing the card with Prioritizing the card proportional to the that's closest to hitting that has the most the highest balance, with the lowest balance, balances owed on its credit limit, to avoid credit room, to enable to maintain equal motivated to have one 97.1% 51.5% each card penalty fee a large purchase balances across cards that’s paid off The share of people’s remaining payment money that optimally The share that actually went to people’s highest-rate cards should have gone to the card with the highest interest rate

They focused mostly on PAYMENT BEHAVIOR ON THREE CARDS PAYMENT BEHAVIOR ON FOUR CARDS PAYMENT BEHAVIOR ON FIVE CARDS their cards’ balances rather than the interest rates HIGHEST BALANCE HIGHEST BALANCE HIGHEST BALANCE CARD 1 CARD 1 CARD 1 Looking at consumers with balances on 55% multiple credit cards, the researchers 60% 45% 60% 60% compared people’s actual-payment behavior 44% LOWEST LOWEST to a calculation of what the monthly ACTUAL-PAYMENT BALANCE BALANCE 38% 36% payments would have been had the payment behavior seen in the data 40% 40% 40% 30% money been divided in proportion to the most closely ﬁts the balances owed on each card. By focusing on BALANCE-MATCHING CARD 5 CARD 2 balances—which are prominently displayed model developed by the on credit-card statements, the researchers researchers—signiﬁcantly note—people underpaid their highest-rate more so than the other CARD 4 CARD 2 cards by more than 20 percentage points. four scenarios they tested.

CARD 3 CARD 2 PAYMENT BEHAVIOR ON TWO CARDS

LOWEST CARD 4 CARD 3 CARD 1 HIGHER BALANCE CARD 3 76% ANNUAL PERCENTAGE HIGHEST APR HIGHEST APR HIGHEST APR RATE CARD 1 CARD 1 CARD 1 57% 52% 51% 60% 60% 60% 60% LOWEST LOWEST 44% 35% APR APR 40% 40% 40% 40% 27% 21% CARD 5 CARD 2 20%

The research reveals CARD 4 CARD 2 that consumers’ ACTUAL-PAYMENT activity put too little toward their highest-rate cards CARD 2 CARD 3 CARD 2 compared to what the OPTIMAL PAYMENT would have been. LOWER LOWEST CARD 4 CARD 3 APR APR CARD 3 INFOGRAPHIC NICOLAS BY RAPP John Gathergood, Neale Mahoney, Neil Stewart, and Jörg Weber, “How Do Individuals Repay Their Debt? The Balance-Matching Heuristic,” Working paper, June 2017.

22 Chicago Booth Review Winter 2017/18 Why people mismanage credit-card debt onsumer-finance experts usually advise people with balances on multiple credit cards to make the minimum payments on all of their cards So what were they thinking? The researchers explored five scenarios: and then put any remaining payments on the card with the highest interest rate. However, relatively few people do that, and research suggests why. According to University of Nottingham’s John Gathergood and Jörg Weber, Chicago Booth’s Neale Mahoney, and University of Warwick’s Neil Stewart, consumers try to manage multiple debts at once rather than pay off the most expensive one. That flawed approach can be costly. The researchers consider a number of explanations, including that people could be repaying the credit card with the highest capacity, € the highest balance, or the lowest balance. Looking at a data set based on records from five major credit-card issuers in the United Kingdom, they pit these explanations against their own theory, “balance matching,” in which payments are proportionate to overall amounts owed.—CB €

CARD 3 CARD 2 PAYMENT BEHAVIOR ON TWO CARDS

Winter 2017/18 Chicago Booth Review 23 COVER STORY NEVER MIND THE 1% LET’S TALK ABOUT THE %

BY HOWARD R. GOLD 024 Chicago Booth. Review01 Winter 2017/18 Some research argues that while 1% of US families hold 41.8 % of the country’s % wealth . . .

. . . the top 0.01% hold more than a quarter of the “1 percent’s” wealth, and 11.2% of the country’s total.

Saez and Zucman, 2016

Winter 2017/18 Chicago Booth Review 25 $40M

$31.6 0 . 0% million average in 2015

$35M

“Since the 1970s, average incomes have grown, but the growth has not been uniform across the income distribution. The incomes at the top, especially in the top 1 percent, have grown much faster than average,” wrote Harvard’s N. Gregory Mankiw, in a 2013 paper entitled “Defending the One Percent.” “These high earners have made significant economic contributions, but they have also reaped large gains. The question for public policy $30M is what, if anything, to do about it. This development is one of ince the Great Recession, the largest challenges facing the body politic.” Mankiw noted that the 1 percent’s share of total income, America’s wealthiest 1 percent excluding capital gains, rose from about 8 percent in 1973 to 17 S percent in 2010, the latest figures available at the time. “Even have been demonized as fat cats more striking is the share earned by the top 0.01 percent. . . . This group’s share of total income rose from 0.5 percent in 1973 $25M who have grown ever richer to 3.3 percent in 2010. These numbers are not easily ignored. Indeed, they in no small part motivated the Occupy movement, while the middle class has and they have led to calls from policymakers on the left to make stagnated. While protesters have the tax code more progressive.” In the nearly five years since Mankiw’s paper, economists called for the 1 percent to be have assembled more data with which to analyze the 0.01 percent. In the 35 years ending in 2015, the share of total income taxed more heavily, economists has accrued faster to the 0.01 percent than it has to the rest of $20M the 1 percent. The share of total income has risen, according . . . and that same 1% have been digging into data to to 2015 data, to 5 percent for the 0.01 percent and 22 percent for the 1 percent. The 0.01 percent’s share of total US wealth divided into four groups: develop a better understanding quadrupled in the 35 years ending in 2012 to 11 percent, argue of who the top earners are. University of California at Berkeley’s Emmanuel Saez and Gabriel Zucman, who have made wealth calculations through 2012. Top 0.01% 0.1%–0.5% These economists have been seeking to measure income Not all economists agree that the 0.01 percent are the most $15M inequality and wealth inequality, and to understand the significant slice of the distribution. New York University’s Edward nature of the 1 percent’s income and assets. And views differ. N. Wolff, using different data, notes that the wealth of the top 5 Some say the 1 percent are predominantly entrepreneurs and percent has grown faster than that of the 1 percent over the past the “working rich,” people who made their money by starting 30 years. Chicago Booth’s Steve Kaplan says that income share and running successful businesses. Other economists note for the 1 percent stagnated between 2000 and 2015. that a significant proportion of the 1 percent are the heirs of But the disparities within the 1 percent have intrigued other 0.01%–0.1% 0.5%–1% wealth accumulated over time. economists. Who are the 0.01 percent? How well are they really But the data also reveal disparities within the 1 percent. doing? How are they making their money? And how, if at all, $10M The 1 percent, it turns out, have their own 1 percent. should policy makers respond?

$5M Average income of the entire top 1% . . . $1.4 million US households, including capital gains (2015 dollars) average in 2015 $2.5M

$0 $0 1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010

Piketty and Saez, 2016 26 Chicago Booth Review Winter 2017/18 $40M

$31.6 million average in 2015

$35M

The 0.01 percent, by the numbers The United States has 325 million people—in 160 million households, as viewed by the Internal Revenue Service. That means 1.6 million households fall into the 1 percent category. The threshold for membership in the 1 percent in 2014 was an annual household income of $386,000, excluding any capital gains, according to Chicago Booth’s Eric Zwick. That’s $30M more than seven times the median household income that year of $54,000. The 0.1 percent, 160,000 families, in 2014 made at least $1.5 million a year. The top 0.01 percent, 16,000 families, had annual income of $7 million. Income share is another way to assess how the strata of the 1 percent are doing. Between 1995 and 2015, the income share (including capital $25M gains) of the top 1 percent rose from roughly 15 percent to 22 percent, according to Piketty and Saez’s data. The income share of the top 0.1 percent rose from 6 percent to 11 percent, and the income share of the top 0.01 percent rose from 2.5 percent to about 5 percent. In terms of percentage points, the top 1 percent’s rose the most. In terms of the rate of increase, the 0.01 percent’s did.

$20M . . . and that same 1% divided into four groups:

Top 0.01% 0.1%–0.5%

$15M

0.01%–0.1% 0.5%–1%

$10M

$5M Average income of the entire top 1% . . . $1.4 million US households, including capital gains (2015 dollars) average in 2015 $2.5M

$0 $0 1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010

Piketty and Saez, 2016 Winter 2017/18 Chicago Booth Review 27 The top 1%’s share of all US income 0 . 0% US households, including capital gains

Top 0.01% Rest of the 1%

25%

After-tax income tells a similar story. For the top 1 percent, it nearly tripled between 1980 and 2014, according to research by Paris School of Economics’ Thomas Piketty and UC Berkeley’s 20% Saez and Zucman. For the top 0.1 percent, it almost quadrupled in the same period. And posttax income for the 0.01 percent rose 423 percent. Posttax income for the entire US population rose by only 61 percent during this time, the study demonstrates. 15% The 0.01 percent also perform best in comparisons of wealth. 16.9% Saez and Zucman, in an influential 2014 study, used income data from the IRS to “capitalize,” or derive, wealth based on the expected aggregate rate of return from every asset class or source 10% of income reported on tax returns. They say the share of total 12.8% wealth of the top 1 percent has increased steadily, from below 25 percent in 1978 to 42 percent in 2012. The share of total wealth of the top 0.1 percent has roughly tripled, and the share of the 5% 0.01 percent has more than quintupled. The top 0.01 percent of US households had at least $111 million in net worth in 2012, 5.1% compared to $4 million for the 1 percent. 2.5% Not everyone slices the data the same way, or draws the same 0% conclusions. New York University’s Wolff, using data from the 1995 2015 Federal Reserve Board’s Survey of Consumer Finances, finds Piketty and Saez, 2016

0.1%–0.5% Top 0.01%

The top 1% divided . . . by income into four groups . . . US households in 2015, excluding capital gains

0.5%–1% 0.01%–0.1%

Average income $18.9of millionthe top 0.01%

Threshold to get into the top 0.01%

0.5%–1% $7.5 million Income threshold to get in: $408,000 Average income: $485,000 0.1%–0.5% Threshold: $606,000 Average: $901,000

0.01%–0.1% Threshold: $1.6 million Average: $2.9 million

$0 $5M $10M $15M

Piketty and Saez, 2016

28 Chicago Booth Review Winter 2017/18 that between 1983 and 2013, the top 5 percent of households saw live in different parts of the country. . . . There is a huge amount of their wealth grow faster than the top 1 percent did. This would diversity, even within a group that we think is small but is actually challenge the notion that wealth is increasingly concentrating at very big, which is the top 1 percent.” the top. He also argues that the rise in overall wealth inequality in the US from 2007 to 2010 is due less to very wealthy people’s Who’s in the 0.01 percent? success than to the middle class’s failures, chief of all taking on When discussing the super-rich, many bring up family dynasties debt only to lose value in their homes. such as the Waltons of Wal-Mart, or the Rockefellers and Koch And Piketty and Saez’s income-share data show that long-term brothers of energy fortunes. They may think, too, of highly paid growth has stagnated since 2000 for the 1 percent, 0.1 percent, corporate executives such as Apple CEO Tim Cook (who made and 0.01 percent, argues Chicago Booth’s Kaplan. All three groups $150 million in 2016, according to Bloomberg), celebrities such as saw their income shares and inflation-adjusted incomes peak in Diddy (who took home $130 million pretax in the year through 2007, and those shares have yet to recover to those pre–Great June 2017, per Forbes), and entrepreneurs such as Facebook Recession levels, he points out. founder Mark Zuckerberg (No. 5 on Forbes’ 2017 list of the University of Chicago’s Greg Kaplan says the main point of world’s billionaires). recent research he did with University of Minnesota’s Fatih But who is actually in the 0.01 percent? Researchers are Guvenen is to highlight that there’s variety in the group so many developing a better understanding of how people in various know as the 1 percent. “When I hear people talk about top income rungs of the 1 percent make their money. And some research inequality, I hear words and phrases such as ‘top 1 percent,’ ‘top 0.1 suggests business income plays a big part. percent,’ ‘top earners,’ ‘CEOs’ . . . thrown around all the time,” he Since the late 1990s, “nearly all of the recent rise in top says. “I think we need to keep in mind that these are very different incomes has come in the form of business income,” write people. They get their income from very different sources. They Matthew Smith of the US Treasury Department, Danny Yagan of

0.1%–0.5% Top 0.01%

The top 1% divided . . . by income into four groups . . . US households in 2015, excluding capital gains

0.5%–1% 0.01%–0.1%

Average income $18.9of millionthe top 0.01%

Threshold to get into the top 0.01%

0.5%–1% $7.5 million Income threshold to get in: $408,000 Average income: $485,000 0.1%–0.5% Threshold: $606,000 Average: $901,000

0.01%–0.1% Threshold: $1.6 million Average: $2.9 million

$0 $5M $10M $15M

Piketty and Saez, 2016

Winter 2017/18 Chicago Booth Review 29 0 . 0%

UC Berkeley, and Chicago Booth’s Owen Zidar and Zwick, whose that profits of companies run by these 1 percent-ers are far higher than work focuses on the 1 percent and 0.1 percent. “The demand those of businesses owned by people in the top 5 –10 percent. In the for top skill has outpaced its supply, with the returns to top skill researchers’ sample, when these businesses’ owners died prematurely, increasingly taking the form of business income.” while still running their companies, profits plunged by more than half. This income is broad-based among the 1 percent. “What’s The average company in the top 1 percent of income has $7 covered on CNBC or in the Wall Street Journal or New York Times million in sales and 57 employees, according to the research. might be overemphasizing the drivers of wealth in Wall Street “If that firm has, say, a 10 percent profit margin to split between and Silicon Valley, and the economy is much bigger and more two owners, it’s enough to put someone in the top 1 percent diverse than that,” Zwick says. “There are a few Carnegies and category,” says Zwick. The businesses earning the most profits in Rockefellers, a Bill Gates and a Jeff Bezos here and there, but the bulk of the top 1 percent were physicians’ and dentists’ offices, there are a lot more people earning between $300,000 and a few professional and technical services, specialty trade contractors, million dollars doing a lot of different things.” and legal services. Smith, Yagan, Zidar, and Zwick find that the 1 percent’s income is To reach the top 0.1 percent of income, the average company being driven by owner-managers, mostly of small and medium-sized has $30 million in sales and 150 employees. “If you’re an auto companies—specifically S corporations, partnerships, and limited dealer and you have five or six dealerships and you’re doing liability companies. These are talented managers: the researchers find $30 million in sales, you have a bunch of workers and you split

Top 0.01% Two 5-year time periods The top The top 0.01%’s share High-income US workers’ top industries 1981–85 2008–12 1% . . . of US wealth vs. the rest of the 1% Share of workers in each industry Researchers’ calculation of cumulative change 0.01%–0.1% 0.1%–1% (percentage points, 1950–2012) Top 0.1% Rest of the 1% $400M Top 0.01%: $371.2 +8 Finance . . . by million +8.4 points and insurance wealth average (11.2% of US +6 wealth in 2012) Researchers’ in 2012 $300M calculation of US household +4 Durable average manufacturing (2010 dollars) +2 Management, $200M accounting, 0 and consulting

−2

Health $100M −4 Rest of the top 1%: +2.9 points (30.6% of −6 US wealth) Wholesale trade $0 −8 1950 ’60 ’70 ’80 ’90 2000 ’10 1950 ’60 ’70 ’80 ’90 2000 ’10 0% 10% 20% 30% 0% 10% 20%

Saez and Zucman, 2016 Guvenen et al., 2014

30 Chicago Booth Review Winter 2017/18 Several studies indicate that nance is an important sector

for the 0.01 percent. $3 million in profits between one or two owners, that would Members of the Forbes put you in that top 0.1 percent group,” says Zwick. In the top 0.1 percent, physicians’ offices ranked only sixth in profits— 400 represent the top behind managements of private companies, financial and investment activities, auto dealers, professional and technical 2 percent of the top services, and oil and gas extraction. 0.01 percent—the top It’s harder to get at the source of income for the top 0.01 percent, but several studies indicate that finance could be an 0.00025 percent of US important sector for the group. Williams College’s Jon Bakija, the US Treasury Department’s Adam Cole, and Indiana University’s households. For them, Bradley T. Heim find that one-fifth of the primary taxpayers in the top 0.1 percent of income (including capital gains) work in finance. nance was the source The latest data used in this study are from 2005, before the 2007– of wealth for almost 10 financial crisis altered the landscape. But between 2008 and 2012, “finance and insurance is by far the most highly represented one in four. industry among the highest earners,” find Guvenen and Kaplan,

Top 0.01% Two 5-year time periods The top The top 0.01%’s share High-income US workers’ top industries 1981–85 2008–12 1% . . . of US wealth vs. the rest of the 1% Share of workers in each industry Researchers’ calculation of cumulative change 0.1%–1% 0.01%–0.1% (percentage points, 1950–2012) Top 0.1% Rest of the 1% $400M Top 0.01%: $371.2 +8 Finance . . . by million +8.4 points and insurance wealth average (11.2% of US +6 wealth in 2012) Researchers’ in 2012 $300M calculation of US household +4 Durable average manufacturing (2010 dollars) +2 Management, $200M accounting, 0 and consulting

−2

Saez and Zucman, 2016 Guvenen et al., 2014

Winter 2017/18 Chicago Booth Review 31 The 20 richest Americans Forbes 400 ranking 0 . 0% by net worth, 2017

Average of the top 0.01% (calculation for 2012) $371 million

who looked at the 0.1 percent. In the rest of the 1 percent, health Bill Gates $89 billion care is the most represented sector. Jeff Bezos $81.5 billion Beyond that, there’s more detailed information about only Warren Buffett $78 billion the very richest of the 0.01 percent, and it seems to suggest that the richest members of the group may own large, successful Mark Zuckerberg $71 billion businesses. Kaplan and Stanford’s Joshua Rauh used Forbes’ Larry Ellison $59 billion “rich list” as a data set on the wealth of the richest Americans. Charles Koch $48.5 billion Since 1982, Forbes has compiled an annual list of the 400 David Koch $48.5 billion wealthiest Americans, using public information, private interviews, and valuations of comparable assets. As the rich list Michael Bloomberg $46.8 billion comprised 400 households, it represents the top 2.5 percent of Larry Page $44.6 billion the 0.01 percent—the top 0.00025 percent of US households. Sergey Brin $43.4 billion But this small group could control more than a quarter of the income in the 0.01 percent. According to Saez and Zucman’s Jim Walton $38.4 billion calculations, in 2012 the top 0.01 percent had an average wealth S. Robson Walton $38.3 billion of $371 million, which would imply a collective total of $6 trillion. Alice Walton $38.2 billion That same year, the estimated combined net worth of the Sheldon Adelson $35.4 billion individuals on the Forbes 400 list was $1.7 trillion. Among the group who made the rich list, for almost one in four, Steve Ballmer $33.6 billion ﬁnance—especially hedge funds and private equity—was the source Jacqueline Mars $25.5 billion of wealth, while 15 percent came from technology-based companies. John Mars $25.5 billion Food and beverage companies accounted for 10 percent. Phil Knight $25.2 billion And these sectors were on the upswing. “The ‘ﬁnance and investments’ category grew in representation by around 16 Michael Dell $23.2 billion percentage points, technology (both computer and medical) George Soros* $23 billion by 11 percentage points, and retail/restaurant by 10 percentage points,” Kaplan and Rauh write. *Forbes published its 2017 rankings shortly before the announcement that Soros has transferred much of his wealth to his foundation. On the 2016 rich list, two-thirds were self-made and one-third had inherited at least part of their fortune. More than 10 percent Forbes; Saez and Zucman, 2016 were immigrants to the US.

How did they get so wealthy? Piketty and Saez have theorized that investments grow faster than the economy, giving entrenched dynasties insuperable Composition of the 0.01%’s wealth advantages. But Kaplan and Rauh argue that the super-rich are Researchers’ calculation, 2012 predominantly creating rather than inheriting wealth. Kaplan also says that wealth in this group has been fueled by a marriage of in- demand skills, globalization, and technology—the combination of which are allowing businesses to scale up as never before. Skills, say many economists, are critical to the modern Business economy. As the US economy grows, jobs are going unfilled as assets: companies scramble to find skilled people to hire. There’s a flip 7.1% Bonds and other side to this: as certain skills have become scarce, this has raised Equities: fixed-income 40.2% the amount companies are willing to pay people who have them. claims: 48.1% The situation has similarly raised the amount of profits skilled company owners can make, and technology and globalization are further magnifying the value of in-demand skills. Pensions: 2.8% If this is true, the 0.01 percent are most likely benefiting from what economists call “skill-biased technological change”—the increasing return on certain skills in an economy driven by Housing: 1.8% technology and globalization. Under this well-established theory, a shortage of in-demand skills raises the value of those skills in rapidly Chart does not add up to 100% because of rounding. expanding markets, and new technology helps some workers’ Saez and Zucman, 2016 productivity grow much more than others’, exacerbating inequality.

32 Chicago Booth Review Winter 2017/18 In the Information Age, the change has been particularly rate, which slid in the US and other developed countries after the pronounced. “In business, you can use technology to do things you Reagan and Thatcher revolutions. The US and UK had tax rates as high couldn’t do 30 years ago,” says Steve Kaplan. “You can scale your as 80 percent, wrote Saez and Piketty in theGuardian in 2013. “The job business using technology, and you can use people in India and China of economists should be to make a top rate tax level of 80 percent at and all over the world—you couldn’t do that as effectively 30 years least ‘thinkable’ again.” But on this, Steve Kaplan disagrees. Raising the ago.” This, he argues, has been spectacularly positive for poorer top marginal rate could send people and their money scurrying for tax people in developing countries. In 1990, the World Bank estimated havens, he says, pointing to France as an example. that roughly 35 percent of the world lived in extreme poverty. Today, Raising the top tax rates in the US could also send people less than 11 percent of the world’s population is so impoverished. to take advantage of more favorable tax rules within the code And it has been good for wealthy residents of developed itself. And closing perceived loopholes can be controversial. For countries. For them, the result has taken the form of the example, some people working in finance benefit from the code’s “superstar” or “winner-take-all” phenomenon, first identified treatment of carried interest, where income flowing to the general in a landmark 1981 paper by the late Sherwin Rosen, who partner of an investment fund is typically treated as capital gains taught at the University of Chicago. “In certain kinds of and therefore taxed at a lower rate. economic activity there is concentration of output among a few “This tax preference is viewed as an unfair, market-distorting individuals,” wrote Rosen. “Relatively small numbers of people loophole by some but consistent with the tax treatment of other earn enormous amounts of money and dominate the activities entrepreneurial income by others,” writes the Tax Policy Center. in which they engage.” Then there’s the issue of whether raising the top marginal rate Technology, from the internet to media such as ESPN and could discourage business activity. The marginal rate is intended Bloomberg terminals, has given elite athletes, entertainers, to tax individuals on their earnings, and it rises with income. entrepreneurs, and financiers the ability to profit on a much larger, But a lot of business income is being taxed at that marginal global scale, making the fruits of their labor more valuable than rate rather than a corporate rate. Because the top US marginal what previous superstars, such as, say, Pelé or Babe Ruth, brought personal tax rate was lower than the corporate rate for some in. Ruth’s peak salary of $80,000 would be worth about $1.1 million time, business owners had an incentive to change their form of in 2016 dollars, one-thirtieth of the $33 million the highest-paid corporate organization from the traditional C corporation, which Major League Baseball player, pitcher Clayton Kershaw of the Los has profits taxed at the higher, corporate rate, to a partnership, Angeles Dodgers, made in salary alone in 2016. limited liability corporation, or S corporation, taxed at the lower, The world’s hundred highest-paid athletes, led by Cristiano individual rate. By 2011, these pass-through entities accounted Ronaldo and LeBron James, stars of soccer and basketball, for most of the business income earned in the US. (For more, see respectively, “banked a cumulative $3.11 billion” over the past 12 “The $100 billion tax dodge,” Summer 2016.) months, Forbes calculated this past June. Among entertainers, Policy makers should design an income-tax system that takes rapper/entrepreneur Diddy and singer Beyoncé each raked in into account the nature of the income, and design a system that more than $100 million over the same period, Forbes estimated. harmonizes taxes to discourage people from shopping the code for And hedge-fund managers make multiples more than the best tax rates, Zwick suggests—recognizing this is a tall order. top athletes and entertainers. James Simons of Renaissance And despite his research interest, Greg Kaplan says we should be Technologies and Ray Dalio of Bridgewater Associates each careful about populist reactions that lead us to focus too much on the made more than $1 billion in 2016, even though, as Institutional super-rich: “We are better off concentrating on how to improve the Investor’s Alpha reported, the top-25 hedge-fund earners lives of those in the bottom 50 percent.” In this group, many workers took in the least as a group since 2005, largely because of the are in desperate need of a skills upgrade. As these workers fall industry’s overall poor investment performance. behind, many economists say, policy makers need to focus on better “Technology allows a hedge fund to be able to manage $20 preparing them for the workforce, perhaps by investing in education, billion and invest it,” says Steve Kaplan. “I don’t think people had working more closely with local companies to determine what the systems and information to do that 20 to 30 years ago. Now they skills their workers need, and removing barriers such as onerous have the systems and the information to do that. That technological regulations preventing people from entering certain professions. (For change is here and is not going away. If anything, it’s getting stronger.” more, see “How to create middle-class jobs,” Summer 2017.) In short, there’s a split among economists. Some argue that income What should policy makers do (if anything)? needs to be distributed more equitably, while others say governments The question of what, if anything, should be done in response to should focus less on taking actions that could inhibit top earners and the spectacular rise of the 0.01 percent is a thorny one, as Mankiw more on addressing the reasons others aren’t as successful. Do we slow acknowledged. “At the outset, it is worth noting that addressing the the 0.01 percent or lift the 99.99 percent, which could be a heavier and issue of rising inequality necessarily involves not just economics but more complex assignment? As the debate continues, members of the a healthy dose of political philosophy,” he wrote. 0.01 percent continue on their course. When policy makers want to address the concentration of income and wealth, the first place some have looked is the top marginal tax Go to Review.ChicagoBooth.edu to see citations for research in this article.

Winter 2017/18 Chicago Booth Review 33 34 Chicago Booth Review Winter 2017/18 Why we should teach people how to lie In some situations, it’s better to be dishonest.

BY CHANA R. SCHOENBERGER ILLUSTRATION BY MATT CHASE

Winter 2017/18 Chicago Booth Review 35

ould you handle being honest—totally, brutally truthful, without even a well- intentioned falsehood to smooth over a social situation—for three days? Most people don’t think they could, at least not without ruining their family, social, and work lives. Fibs, white lies, and half-truths (along with, perhaps, more egregious whoppers) are such Can important part of our interpersonal tool kit that going without them seems next to impossible. But Chicago Booth’s Emma Levine, along with Carnegie Mellon’s Taya R. Cohen, asked exactly that of a group of research subjects and came away with a surprising conclusion: it’s not as bad as it sounds.

The researchers asked some spectrum of ethics from truth telling to lying, we come closer participants to be completely honest in to understanding why we do, or don’t, tell one another the every interaction, with every person in truth, and what this means for our society. their lives, for three days, while other There are, after all, documented social benefits to participants were asked simply to be being dishonest. People often lie in the service of being kind or conscious of their words. The kind; when kindness and honesty are at odds, the former participants predicted that being forced often wins, because “we trust people who are kind,” says into honesty would make them unhappier University of Pennsylvania’s Maurice Schweitzer, who was than if they had to be kind or just aware Levine’s dissertation advisor. We have a tendency to be of what they were saying to others. They more forthcoming to kinder people, particularly friends anticipated frayed relationships as a result and colleagues. of abandoning the lies they typically use But purpose matters, of course: those who transparently to cover up awkward or uncomfortable lie simply to make themselves look good don’t enjoy the same situations. But being honest didn’t torpedo social benefits. The truth is, we care more about others’ good subjects’ friendships, family connections, intentions than their honesty. or jobs. “The experience of being honest is far Lying in the workplace more pleasurable, leads to greater levels of As in social contexts, lying can have positive or negative social connection, and does less relational effects in the business world. When evaluating the harm than individuals expect,” Levine and acceptability of lying, people often consider two things: the Cohen write. immediate emotional harm that telling the truth could cause, The study is part of a movement and the potential long-term value it could create. In most within behavioral science to determine cases, people believe you should tell the truth. But if the how important honesty is to human truth causes emotional harm and cannot create long-term interactions. As researchers explore the value, many people endorse lying.

36 Chicago Booth Review Winter 2017/18 For instance, imagine that a colleague is about to make a uncompromising policy of truth may big presentation and asks for your opinion on his suit, which be less problematic than it sounds for you believe is quite ugly. People are much more likely to most people, such as those in Levine’s believe it is acceptable to lie to the colleague and tell him he three-days-of-honesty experiment, looks fine if he is already wearing the suit and has nothing well-intentioned deception still has else to change into. But if the colleague asks your opinion its value. the day before the presentation, when there’s time for him to wear a different outfit, most people would say you should Frankly speaking tell him how you really feel about his clothes. What matters The tension between kindness and is “the extent to which feedback or any truthful statement honesty can be seen in the language actually provides instrumental value,” Levine says. patterns that we use. English speakers Schweitzer says that to keep honest feedback from regularly preface cutting remarks overwhelming staff, managers should focus on specific with “frankly” or the more slangy business-related issues that need work and skip issues that “not gonna lie”; the concept has even the person can’t control. been abbreviated, for social media Though it’s possible to be honest without being fully purposes, to “tbh,” short for “to be transparent, the same principle of practicality can be honest.” applied to decisions about transparency: in some cases, “It’s just a linguistic marker people transparency for its own sake could be counterproductive. use to say, ‘Don’t blame me for what For instance, calls for full transparency on pay within an I’m about to say,’” says Levine. Such organization are “nonsense; it will make people miserable,” a phrase is meant to absolve the Schweitzer says. Sharing salary figures could rattle a speaker, giving her a moral out. company’s social dynamics. Some employees are solid In a 2014 paper, a trio of performers, but “when they learn that others are being paid researchers—Emory’s Ryan Hamilton, more, they become miserable, sulky, and less productive,” University of Minnesota’s Kathleen he says. Though pay transparency may be motivational for D. Vohs, and Chicago Booth’s Ann some people, and can help combat discrimination, it could L. McGill—looked at the language of also be disruptive for many teams. honesty in online customer reviews. In a series of five experiments, they Is silence golden? find that reviews with “dispreferred In another study, Levine looks at whether it’s better to say markers”—phrases such as “I’ll be nothing or to lie in a situation where lying provides comfort honest,” “God bless it,” “Don’t get and hope, and the truth would be hurtful. Her research me wrong,” or “Bless its heart,” finds that while the communicator—the person making the which indicate reviewers’ desire to choice about lying—often thinks the best thing to do is to say offset negative information—were nothing, thus sparing oneself the guilt of lying, the target considered more believable. prefers to hear the lie. Participants felt that reviewers who “In certain cases, such as the ill-fitting attire, [the target] included these phrases in their might walk around feeling anxious if he realizes that you are comments were more likable than not commenting on the suit,” she says. those who didn’t. When a review It’s a complicated question. In health-care situations, for used this language, participants were instance, both doctors and patients think honesty is best. If also more likely to pay more for the you have cancer, most people agree that your doctor should product being reviewed and to be tell you this scary news gently but frankly. more satisfied with it, the But because hope is important to their mental state researchers find. as they fight the disease, patients sometimes prefer that “More than homey sayings, their doctor gives them hope, rather than giving them no dispreferred markers act as a social information at all. For example, a patient might find comfort lubricant, allowing an otherwise in her doctor telling her that she has a chance to beat the sticky interaction (the communication cancer, even if, medically speaking, she doesn’t. Avoiding of negative, and therefore potentially the topic doesn’t work in this situation, because a lack of a threatening, information) to operate prognosis is disconcerting to the patient. smoothly,” they write. “False hope at least provides hope, while omission doesn’t Cultural norms can complicate provide any emotional benefit,” Levine says. Though an this picture. In Japan, for instance,

Winter 2017/18 Chicago Booth Review 37 lying is common, Schweitzer says, corruption, can be traced to individual bad actors, and that because the culture places a premium companies have little sway: the best they can do is to root on avoiding conflict, particularly out these people by careful screening, hiring, monitoring, avoiding saying “no.” Japanese and firing. language patterns contain ritual A body of experimental work on dishonesty and ethics phrases that are polite to repeat in demonstrates that this narrative is incomplete. Some people conversation whether or not they are lack morals entirely, but small acts of immorality form a more true, Schweitzer says. pervasive problem. “What the research my colleagues and I conducted shows Everybody lies is that all of us, no matter how much we care about honesty, What research cumulatively shows tend to behave unethically when faced with an opportunity to is a disconnect between our official cheat,” Harvard’s Francesca Gino says. Pretty much everyone moral view of honesty and what cheats, as long as they can justify or rationalize their behavior people actually do and how it makes at the time. them feel. And needless to say, this That’s why studying dishonesty quickly turns into a ambiguity doesn’t just manifest itself question of how to remind people that their morals are when people are motivated by important to them. good intentions. “It is more about making sure that we are aware of the In the corporate world, it takes the forces that lead us astray when it comes to ethics and figuring form of widespread ethics scandals, out ways we can remind ourselves that morality is something such as 2016’s Wells Fargo imbroglio, we care about,” Gino says. which resulted in the US Consumer In a 2012 study, Gino and her collaborators worked with an Financial Protection Bureau fining auto-insurance company to see how honest customers were the bank $100 million for “the in reporting the mileage from their car’s odometer, a standard widespread illegal practice of secretly part of the insurance process that helps determine premiums. opening unauthorized deposit and Higher reported mileage means a customer’s premium is more credit card accounts.” A year earlier, likely to rise. Half of the customers were given the company’s the US Environmental Protection usual form, which asked them to sign the following statement Agency accused German automaker that appeared at the bottom: “I promise that the information Volkswagen of installing software on I am providing is true.” The other half filled out a revised clean-diesel cars to help them cheat version of the form, in which this statement was located at on emissions tests. Cases of the top. ethical misconduct span industries Among those who signed the pledge at the top of the and decades. page—before filling out their odometer readings—the average But why? The conventional reported mileage was more than 2,400 miles higher. explanation is that dishonesty and “Our follow-up research demonstrated that signing at the its attendant problems, such as top of the form (before reporting information that could be inflated) increased the salience of ethical standards by highlighting people’s self-identity and improving their ethicality, so the disparity in average mileage suggests a difference in reporting ethics rather than in driving habits,” Gino says. The behavioral “nudge” of asking participants to make an initial promise to be honest seemed to work by reminding them of their own morals. Some situations do allow for dishonest actions to be seen as “All of us, no matter how “less morally problematic,” Gino says. For instance, research has shown that crossing ethical lines to help others is often much we care about honesty, viewed in more of a neutral light, as is cheating that involves tend to behave unethically creativity, she says. How pervasive is dishonesty? Duke’s Dan Ariely examined when faced with an that question in his 2013 book, The Honest Truth about Dishonesty: How We Lie to Everyone—Especially Ourselves. opportunity to cheat.” Ariely, a behavioral economist, also set up a video booth, the — FRANCESCA GINO “Truthbox,” to capture ordinary people talking about their

38 Chicago Booth Review Winter 2017/18 own dishonesty, from fibs to whoppers. Posted on YouTube, Schweitzer says. Instead, we send a the videos reveal people who use lies as excuses, or to make mixed message, insisting that one things easier in social situations. One woman explains that should never lie and at the same time she is chronically late and always blames her tardiness on rewarding some lies. Children are train trouble or other transparent fictions. She muses that admonished for dishonesty in one she assumes her friends know she’s lying, because everyone breath and, in the next, encouraged to knows that she’s always late. tell Grandma how much they like the Another woman explains how she tells people her father new sweater she bought them. Rather died when she was young, but omits that he was abusive. “It than condemning lying altogether, doesn’t feel safe for me to tell people that level of truth about Schweitzer suggests, we should move something that tragic, so I filter it,” she says. to a set of ethics based on what we Her story is an illustration of our complicated relationship understand about behavioral science. with lying. Our moral code tells us that lying is wrong, yet “Let’s give people guidance, we intuitively act in ways that demonstrate how lying is because we can identify broader rules often the right thing to do. “My broad claim would be that here,” he says. as managers, as teachers, as parents, we should teach our Go to Review.ChicagoBooth.edu to see citations employees, students, and children when and how to lie,” for research in this article.

Winter 2017/18 Chicago Booth Review 39 40 Chicago Booth Review Winter 2017/18 Winter 2017/18 Chicago Booth Review 41 42 Chicago Booth Review Winter 2017/18 Winter 2017/18 Chicago Booth Review 43 JOHN C. HEATON Co-faculty Director of Private Wealth Management, Deputy Dean for Faculty, and Joseph L. Gidwitz Professor of Finance

GAIN THE FRAMEWORKS TO PRIVATE WEALTH PROTECT AND GROW YOUR WEALTH MANAGEMENT Exclusively for High-Net-Worth There are many roads to growing and protecting Individuals and Families business and ﬁnancial capital while reinforcing Gleacher Center, Chicago personal values that support a ﬂourishing family. In the April 24–27, 2018

Chicago Booth Private Wealth Management program Optional Investment for high-net-worth individuals and families, you can Fundamentals Session: April 23, 2018 explore the options and then decide which ones are right for you and your family. For more information, visit ChicagoBooth.edu/PWM or call 312.464.8732 to submit an application. What venture capitalists can learn from ‘racist’ rats Page // Can Amazon ﬁ ll your every need? Page Watergate and presidential power Page // Did poor regulation fuel the ﬁ nancial crisis? Page

Everiatem discil expel modit mollantecti con repro tendt quam quia comni unt.

hicago Booth’s Eugene F. Fama a matter of arithmetic, not a hypothesis. weighs in on market effi ciency, A simple way to think about it is: active active management, and managers can’t win at the expense of corporate governance, among passive managers, because passive EUGENE F. FAMA Cother topics, and explains why investors managers hold cap-weight portfolios of shouldn’t buy hedge funds. the entire market or of subsets of the market—which means, they don’t really On effi cient markets respond to the actions of active managers. Embrace People say, “Information is much more available. We have the internet. We have On factor investing passive much faster computers. Are markets Forget timing factors. That’s ridiculous. more or less effi cient than they were in A company that I’m involved with management the past?” I can’t tell. They’ve always [Dimensional Fund Advisors] does it looked very effi cient. I don’t see any passively. They just buy the whole value improvement or degradation. segment of the market, or the whole already small segment of the market. They’re not Some advice from the father On active versus passive investing trying to pick winners or losers. Timing is There is no debate whether active even more subject to error than picking of effi cient markets management is better; it can’t be. That’s individual securities.

ILLUSTRATION BY MICHAEL BYERS Winter 2017/18 Chicago Booth Review 45 On financial products for financial advisers are getting In academic finance, there are three These robo-things negotiated downward. I don’t think to five ideas that survive every 20 are just a technolo y there’s much 1 percent any more, years. In marketing and applied except at the low wealth end. finance, there are 10 new products tool that will help a week. But the key to all of it is On portfolio construction robustness. People are too ready to advisers in the end, When I talk to institutional investors, come out with products based on I like to chide them that they change things that are flimsy statistically. not hurt them. their portfolio allocations based on When academics do stuff, we always three to five years of past returns, and look for other time periods and go that’s basically noise. There’s to other markets to see if we see no information from that about similar things. If we don’t, we don’t expected returns. trust them. If they have absolutely no relation to theory anywhere, we On robo-advisers don’t trust them. In the end, these are going to be a boon to professional advisers. They’re On corporate governance going to be a way advisers can show It’s better than it was because of the their clients what distributions of professionalization of investment outcomes possibly look like with and the fact that we have investment different investment strategies. managers who take it seriously. I play a lot of golf with a lot of rich Passive funds have gotten big people. When I talk to them about enough that they realize they have their portfolios, they don’t want to responsibility to their investors. bother with them, basically. They They want to deliver value. They want an adviser, and they do not don’t want the value to be stolen want to be involved in investing on a by the insiders, so they’re into day-to-day basis, because their value corporate governance. I mean, at added is somewhere else. I don’t Dimensional, we have 20 people that think that’s going to change. These just do corporate governance. I think robo-things are just a technology tool it’s probably similar at other places. that will help advisers in the end, not We have rules such as: if a board hurt them. member of a company votes in favor of a poison pill, we’ll follow that On algorithmic trading director for the rest of his life and It could make the market more vote against him no matter where efficient, or it could lead to problems. he goes. Lots of it does seem wasteful. All of this investment and capital to just be a On active managers microsecond in front of everybody else Being good at active management, seems a bit wasteful. that’s a human-capital skill. That person is going to charge high On proposals for transaction taxes enough fees to absorb the rents that I hate them. The more you interfere she’s creating. Investors are always with markets, the worse off you’re going to be just as well-off buying going to be. passive, even if they can identify who the good active managers are. On market structure We have competition among markets On financial advisers now. That’s the way you want to see When Dimensional started dealing it. Let’s see what survives out of all of with financial advisers, I said to that. Governments are never in a good them, “Your business model has to position to regulate things like that. change because just doing portfolio I mean, insider trading, maybe. But management is not worth 1 percent actually regulating the mechanisms a year. You’re going to have to get of the market is tricky because they into other aspects of the business. change so fast. You’re going to have to do general wealth management and, maybe, life More from Nobel laureates On market regulation insurance, accounting, all kinds of Visit our website to watch Fama and When the NASDAQ market came other things.” Richard H. Thaler discuss whether online, there was a quiet period, and The adviser business has definitely markets are efficient. then in the late 1970s, early ’80s, they moved in this direction. The fees loosened the listing requirements.

46 Chicago Booth Review Winter 2017/18 Now, they didn’t do that on their I’ve never been able to explain own. There was a demand for it. why these things exist. They They figured out that people were demonstrate, absolutely, the willing to hold companies that phenomenon of money moving weren’t profitable when they went quickly based on noise. . . . You public. There was an explosion in expect extreme returns, one way listed companies—and listings grew or the other. After you take off the until about 1996. Since then, the 2-and-20 you expected, on average, number of listed companies has fallen you’re going to be down. Because dramatically. I think it’s 30 percent hedge funds are subject to the lower at this point than it was then. arithmetic of active management, You say, “Maybe there were too they’re part of that game. many listed companies.” But the really frightening part of it is that it’s also On changes in academic finance happened for nonlisted companies. In the 1960s, there were two places If you look at business formation, it’s doing serious research, Chicago and tanked in the same period. And that’s MIT, as well as Carnegie to some where the dynamics of the economy extent. But now, every university really sit. This has a lot to do with has a pretty good finance group with regulation. It’s just so hard to start a really good people in it and they’re business. It’s so expensive. You can’t all doing similar sorts of things. The go into the financial business now challenge is to figure out what is the without having compliance from result of data dredging and what is day one, which means you have to the result of something real. But have a certain amount of capital that that’s a good challenge to have in you didn’t need 30 years ago. So it’s the sense that you’ve got a lot of much more difficult to start a financial talented people out there doing really business, and I think that’s true across good things. the board. Unwinding all of that, my preference On building a financial would be that every regulation has to business today be renewed every three to five years, I would focus on providing a full range otherwise it lapses. Of course, nobody of products, not simply investment listens to me! products but financial management or wealth management products. On private equity Estate services, maybe even tax The private-equity market has services—all of that—and portfolio expanded into somewhat bigger management, I think, can be done as a stuff, but that’s different from market part-time activity. efficiency, in the sense that people can What an adviser has to do in have good ideas and not be able to rebalancing portfolios, that’s not manage a company, or have the capital really a full-time job if you have a to implement their ideas. A private- pretty clear picture of where you equity company can provide both these want to be and how to get there. But things, management and capital. I have the rest of it is, or can be, a full-time no problem at all seeing higher returns job. So that’s what I would do if I to private equity. The problem is, you were in that end of the business. can’t measure the returns to private If I were in the If I were in the institutional end of equity because they’re all self-reported. institutional end of the business, hiring people, what I’d You don’t get to see the bad ones. say is, “Cut the staff down and go Again, there’s a warning because the business, hiring passive.” I’ve been saying that to this is a human-capital activity. When it the university’s endowment for 50 works well, the returns should go people, what I’d years. They’ve never followed my to the private-equity managers, not say is, “Cut the sta advice, and it would be a much bigger the investors. endowment now if they had. and go passive.” I’ve On hedge funds Eugene F. Fama is Robert R. If you want to get poor quickly, you been saying that McCormick Distinguished Service should go into them. If you believe the Professor of Finance at Chicago Booth. arithmetic of active management, why to the university’s This was adapted from a dialogue at would you pay anybody 2-and-20 [2 endowment for the CFA Society Chicago, where Fama percent of total asset value, 20 percent was interviewed by Kepos Capital’s of any profits]? 50 years. Bob Litterman.

Winter 2017/18 Chicago Booth Review 47 in the middle of the box in a trap that could only be opened from the outside. Rats, in general, do not like to be out in open spaces, where they can be spotted by predators—but, astonishingly, the free rat risked its own WAVERLY DEUTSCH exposure to rescue the rat in the trap. Mason had discovered empathy in rats. Every discovery leads to more questions, What venture and in this case, Mason wondered, how deep did the empathy go? She reasoned that capitalists her lab rats were familiar with each other— bunking and often learning new skills together. But would they rescue rats they can learn had never met? Mason put newcomers into the traps. Lo and behold, her rats rescued from ‘racist’ the strangers. Was the empathy linked to genetics? rats Scientifi c labs use white rats for their experiments, and most of these rats have Science sheds light on the been crossbred for generations. Mason importance of familiarity brought in some genetically distant black rats, and when one of these was put into the eggy Mason, a renowned professor trap, the result was dramatically diff erent. of neurobiology at the University The free white rat did not go to the black of Chicago, set out to discover the rat’s rescue. biological basis of empathy. To do Mason wondered if the white rats were Pthis, Mason and her team created a unique racist, responding to a genetic call, or if test for her lab rats, which started by placing the issue was familiarity. She had the white two rats in a large box. The fi rst rat was free and black rats room together for a while to move about, and the other was placed and repeated the test. This time white rats ILLUSTRATION BY JOHN KENZIE JOHN BY ILLUSTRATION

48 Chicago Booth Review Winter 2017/18 rescued black rats—those with which they Another explanation for the gap: women had bonded, and even black rats they’d Male-led start-ups tend to create businesses that do not fit the never met. normal VC profile. That’s not completely As one further test to understand the role raised ve times true either. PitchBook data from 2010 to of genetic pull versus familiarity, Mason took the amount of 2016 suggest that women entrepreneurs are newborn white rats, separated them, and somewhat underrepresented in software— raised each one in a litter of black rats. These capital the female- the biggest category for overall investment, little rats never saw other white rats; they with 39 percent of all venture dollars—and only knew their black litter mates and packs. led ones did. overrepresented in consumer products When one of these rats was placed in the and recreation, which represent a meager box with a trapped white rat, it did not come 4 percent of venture deals. But women to the rescue. The trapped white rat was as current crop of unicorns—private companies entrepreneurs are well represented in the unfamiliar to the free one raised by black rats valued at over $1 billion—were founded by five other most popular segments for venture as the original black rat had been to the white women. VC firm First Round Capital looked investment, including STEM-heavy fields. (See rats who had never seen black rats before. at its portfolio of 300-plus companies “Out of proportion, but not everywhere,” I have oversimplified the research, and 600 founders and discovered that page 50.) which is told in all of its scientific detail in investments with at least one woman on the the journals Science, elife, and Frontiers founding team performed 63 percent better Hire more women venture capitalists! in Psychology. But it sheds light on the than all-male teams. Actually, it’s not that simple importance of familiarity—and by extension Many possible explanations have Looking at the effect of homogeneity in the the problem that familiarity bias creates for been proffered for the VC funding gender investment process—investors favoring those human beings. We make assumptions about gap. One is that women don’t ask for VC who are “like” themselves—is a fruitful line who is like us and who is different from us, money at the same rate men do, which is of research. A 2014 study by the late Ola and these assumptions affect behavior, and the case, but women ask for VC money Bengtsson and David Hsu of the University of can be costly. far more than 2 percent of the time. One Pennsylvania indicates that having a shared recent study by Malin Malmstrom, Jeaneth ethnicity nearly doubles the chances of getting Female founders are getting overlooked Johansson, and Joakim Wincent of Luleå an investment from a particular investor (even This issue of familiarity is an important one University of Technology looked at 125 though the same research finds that shared in venture capital, where one of the biggest applications for venture money and found ethnicity is associated with worse investment stories right now is how little of VC funding that 21 percent were led by women. Yet 53 outcomes). This research has led many to goes to female founders. Fortune’s Valentina percent of female-led start-ups were denied call for the VC industry to hire more diverse Zarya, drawing on data from PitchBook, a funding, compared to 38 percent for male employees, including women, who would leading venture-finance research platform, entrepreneurs. Not only were female-led presumably invest in women. reports that while nearly 5 percent of deals start-ups funded less often; the ones that However, in a small industry such as in 2016 went to companies with female were funded secured less money. The venture capital, which employed 2,105 active founders—up from just under 3 percent a women received 25 percent of what they investors in 2016, it is no easy task to radically decade ago—the dollar amount going to these asked for, while the men got more than half change the number of women hired. Data companies represented a paltry 2 percent of of their requested amounts. from Crunchbase, a comprehensive database total investment, despite the fact that women In another study, by Columbia’s Dana of venture deals, indicate that the pipeline represent a third of private-company owners Kanze, Mark A. Conley, and E. Tory Higgins of qualified candidates in the industry is in the United States. This 2 percent was the and University of Pennsylvania’s Laura Huang, relatively narrow, with only 22 percent of third lowest percentage in the last 10 years, 189 entrepreneurs pitched at the TechCrunch female VC employees on the investment side behind 2008 and 2012. Not only do a tiny Disrupt event in New York. Their start-ups at the associate, vice president, and principal handful of women receive venture funding, had been fully vetted and were of comparable levels. And venture capitalists are slow to hire the amount they are able to raise has fallen. quality, and 12 percent had been founded by new partner-level employees. The average amount of money invested in women. Male-led start-ups raised five times There’s also no guarantee that women, once women-led deals fell from $6 million in 2015 the amount of capital the female-led ones did. hired, will seek out female entrepreneurs to to $4.5 million in 2016—compared to the invest in. Research by University of Colorado’s average deal size for male entrepreneurs of Stephanie K. Johnson and David R. Hekman $10 million in 2016. More from Waverly Deutsch suggests that in the corporate world, there is Logic dictates that deploying only 2 Read more columns about a penalty for women and minority managers percent of investment capital with female entrepreneurship on and executives who promote and advocate entrepreneurs means venture capitalists are Review.ChicagoBooth.edu. for people “like” themselves. The study missing opportunities. Six percent of the used two techniques to isolate this risk: the

Winter 2017/18 Chicago Booth Review 49 researchers compared responses to surveys The evidence suggests that the presence 7 percent of female investment partners in of 350 executives (with questions on topics of a female investment partner at a VC top VC firms were women. Among the top that included diversity in hiring) with results firm does not dramatically alter that firm’s 100 VC firms, 62 had no female investment of the same executives’ 360-degree-feedback propensity to fund women entrepreneurs. partners at all, 28 had one, seven had two, reviews, and they ran an experiment in A 2014 study by Harvard’s Alison Wood and only three had more than that. The which businesspeople were asked to rate the Brooks, Penn’s Huang, Sarah Wood Kearney presence of female investors didn’t seem to competence of a hypothetical hiring manager. of PRIME (a charity that directs investment significantly affect whether a firm had more The research finds that female and minority to fight climate change), and MIT’s Fiona than the average number of female founders managers who hired women and minorities E. Murray finds that women and men in its portfolio. Similarly, Kanze, Huang, were given substantially lower performance were twice as likely to invest in males over Conley, and Higgins find that 40 percent of ratings, penalized by bosses and experiment females, and that the gender of the investor investors at the TechCrunch Disrupt event participants, even though white men weren’t did not significantly affect this ratio. This were female, and the women entrepreneurs penalized for hiring white men. Might new held true even when men and women were still raised less money than the men. female investment partners feel they risk pitching the same business. Venture capitalists, women and men, similar penalties if they actively support More recently, Crunchbase’s Gené Teare apply different standards and language women entrepreneurs? and TechCrunch’s Ned Desmond find that to male and female entrepreneurs. Men are often promoted on their perceived Out of proportion, but not everywhere potential, while women are promoted on their past performance, a 2011 McKinsey PitchBook data show that women entrepreneurs are somewhat underrepresented in report on corporate promotions indicates. software—the biggest category for overall investment—and overrepresented in the consumer products sector. But they are well represented in other popular categories. The study by Malmstrom, Johansson, and Wincent finds this effect exists in Sectors’ share Female founders venture investing as well. By recording the of all VC deals with VC funding sessions where two female and five male 2010–16 By sector, 2010–16 venture capitalists discussed potential investments, the researchers discover Sector that the venture capitalists used different language to describe entrepreneurs who were, aside from gender, fairly similar. They described men as “young and promising,” 38.6% 14.5% Software “experienced and knowledgeable,” and “cautious, sensible and levelheaded,” while they described women as “young but inexperienced,” “experienced but worried,” or “too cautious and does not dare.” 9.9% 12.6% Commercial Kanze, Huang, Conley, and Higgins’s services study mirrors these findings, in a way: the researchers identify that two-thirds of the questions posed by investors to male entrepreneurs were promotion oriented, 6.8% 11.8% Health-care devices asking about the potential of the business and supplies and the entrepreneurs’ hopes. Meanwhile, two-thirds of the questions for the female entrepreneurs were prevention oriented, focusing on risk reduction and security. 6.3% 17.6% Questioners asked men about customer Pharmaceuticals acquisition, but they asked women about and biotech retention; men about revenue growth and milestones, but women about time to breakeven; men about market-size potential, and women about defending 4.9% 15.5% Health-care market share. Entrepreneurs who fielded services promotion-oriented questions were awarded $16.8 million on average, while those asked mainly prevention-oriented questions received an average of $2.3 million in funding. Investors want companies 3.9% 28.2% that have large exit potential, not those Consumer goods most likely to preserve capital, and the and recreation way the questions are phrased can push entrepreneurs into answering in a way that

Deutsch, 2017 reinforces perceptions. KENZIE JOHN BY ILLUSTRATION

50 Chicago Booth Review Winter 2017/18 Familiarity: The problem and hire more women and perform better— the solution Venture capitalists increasing deal success and internal rate-of- It may take some time to meaningfully used di erent return metrics by 3 percent. increase the number of female investment VC fi rms could also add women to their partners in the VC industry, and for those language advisory boards. I work with OCA Ventures, women to feel empowered to champion a leading tech investor in Chicago, and the female entrepreneurs, but research suggests to describe partners there will attest that I bring them that just having women on the investment entrepreneurs investment candidates that feature female team improves the performance of the founders, and I make sure the issue of team women-led portfolio companies. University who were, aside composition and diversity is discussed. of Alberta’s Sahil Raina discovered that only Seeking out and networking with the most- 17 percent of female-led venture-backed from gender, successful female entrepreneurs in your start-ups had successful acquisitions or region can only expand the accessible pool initial public off erings, versus 27 percent of fairly similar. of female talent in hiring, deal sourcing, due the male-led companies. But when Raina diligence, and portfolio support, and help controlled for the presence of a female identify promising female entrepreneurs. investor on the funding team, the gap Finally, being aware of internal bias can coordinator, neither of which is subject to completely disappeared, which suggests that help investors better coach and mentor the same requirement. the relationship between the founder and female entrepreneurs. These investors can Tech giants including Amazon, Facebook, her investors, who also serve as coaching and avoid the promotion-versus-prevention- and Intel, as well as several government governance partners, makes a diff erence. oriented bias eff ect, by consciously scripting agencies, have voluntarily implemented To build a pipeline of female employees, their due diligence interviews, plus they their own forms of the Rooney Rule. A venture capitalists should implement can encourage female entrepreneurs to similar eff ort could force venture capitalists a form of the Rooney Rule, which the reframe interview questions themselves. to expand their networks and broaden their National Football League uses to increase One of the most interesting discoveries searches for talent, and could make women diversity in its hiring practices for head in Kanze, Huang, Conley, and Higgins’s aware of these jobs. coaches. Proposed in 2002 by Dan study is that when the entrepreneurs What, besides hiring female investment Rooney, the late owner of the Pittsburgh who were presented with predominantly partners, can venture capitalists do in the Steelers, after two teams fi red minority prevention-oriented questions chose to give short run to fi nd and fund more of the best coaches who had winning records, the rule promotion-oriented answers, eff ectively female entrepreneurs? Looking back at our mandates that teams interview at least one changing the question orientation, they rats provides some clues. White rats only minority candidate for their head-coaching mitigated the negative eff ects of the bias. needed a short time living with the black rats vacancies. No requirements are placed on This allowed them to raise about $8 million, to see them as fellow rats. Familiarity is a hiring, merely on increasing exposure to while entrepreneurs who answered with subtle thing. VC fi rms need to increase the minority applicant pool. By 2006, the prevention-oriented responses received their level of exposure to women investors percentage of minority head coaches in $563,000. the league had jumped from 6 percent to and entrepreneurs. For starters, fi rms could hire men 22 percent. Today, eight of 32 teams have Waverly Deutsch is clinical professor and with teenaged daughters. Research from minority head coaches. Northwestern PhD academic director of university-wide Harvard’s Paul Gompers and Harvard PhD candidate CC DuBois fi nds that a minority entrepreneurship content at Chicago Booth. candidate has a 20 percent better chance candidate Sophie Q. Wang suggests that of being hired as a head coach in the NFL when venture capitalists hire male partners Go to Review.ChicagoBooth.edu to see citations for than at the college level or as an NFL who have teenaged daughters, those fi rms research in this article.

Winter 2017/18 Chicago Booth Review 51 ILLUSTRATION BY GLEN GTYSSLERGLEN BY ILLUSTRATION

52 Chicago Booth Review SeasonWinter 2017/182016 PHOTO BY GLEN GYSSLER is knowing when it is time to buy more detergent. Accordingly, manufacturers introduced transparent “windows” in PRADEEP K. containers of liquid detergent so consum- CHINTAGUNTA ers could gauge when they were running low. Another step is the act of pouring the detergent. To help customers avoid making a mess on the side of the con- tainer or dripping detergent on the fl oor, With Whole manufacturers added spouts designed to ease pouring, as well as channels to allow Foods, can excess detergent to drip back into the bot- tle. (Manufacturers are more reluctant to A m a z o n l l add clearer markings than they currently do on the insides of caps that would help your every customers measure detergent according to the size of their loads, since they would rather customers use more detergent need? than required.) It’s trying, by embracing Amazon has taken the idea of mapping the customer’s journey beyond merely ful- scope, scale, and speed fi lling a specifi c need to trying to address all the needs a customer might have over mazon’s recent acquisition of the course of a day. In many instances, Whole Foods has triggered a lot this goal involves providing services that of discussion about the motives complete the need-fulfi llment journey behind the purchase. But many for specifi c categories. In the detergent Aof these explanations can be rationalized example, after a customer recognizes that by looking at Amazon’s primary mission, he needs to buy detergent, he still needs which says, “At Amazon, we are committed to go to the store, pick the product from to being the most customer-centric the shelf, pay for it, come home, and use company on earth.” That is not only a it. Amazon is able to help a customer rather audacious statement; indeed, it is complete nearly all of these steps through a tall order. And while some people may Amazon Prime Now, a single service that in the past have perceived the mission delivers products within two hours of statement as purely aspirational, over time, an order. with moves such as this acquisition, it is But Amazon has gone beyond even increasingly clear that Amazon is trying to this by creating ways to make the process make what seemed aspiration into a reality. simpler. The fi rst is the Amazon Dash One way in which marketers often Button, a physical button that customers approach customer analysis is by studying press when they need a specifi c product. what has been referred to as the cus- If you’re running low on Tide detergent, tomer’s “journey,” or the “consumption press the Tide Dash Button that you’ve chain.” Essentially, studying this journey affi xed to your washing machine to order includes mapping the steps that a custom- more. However, while Dash buttons er goes through when fulfi lling a specifi c solved a specifi c problem, Amazon also need, then trying to make sure that your created the Echo speaker, which takes company’s product can fulfi ll that need. voice commands. Echo obviates the need For example, let’s say a customer needs for multiple Dash buttons while also to wash clothes. With the consumption off ering other, unrelated services, includ- chain in mind, one can trace a number of ing the ability to control devices such as innovations that detergent manufacturers alarms and radios. have incorporated into their products over A customer’s daily activities include time. One step in the customer’s journey more than washing clothes, of course—

Winter 2017/18 Chicago Booth Review 53 they also include waking up, eating break- done this aggressively and expansively, by terms from suppliers, while having efficient fast, taking a shower, getting dressed, go- meeting a core or “primitive” need first, operations keeps a further lid on costs. ing to work, returning from work, relaxing and then layering on top of this need to And then there is speed. One-stop, low- in front of the television, preparing dinner, meet additional needs over time. cost shopping is certainly attractive, but if a and going to bed. It is not hard to see how, customer’s need is not immediately met, the over time, Amazon has increasingly crept Scope, scale, and speed shopping experience will not be fulfilling. into these activities—by delivering grocer- To be more customer-centric, Amazon has This is where speed comes in: having more ies for breakfast, toiletries to use in the clearly recognized the power of the three locations conveniently located close to bathroom, clothes to wear, television and s’s: scope, scale, and speed. In order to the customer will enable Amazon to fill a content to enjoy while relaxing, and more become the one-stop destination for the variety of orders inexpensively and quickly. groceries as well as other food delivery consumer, what Amazon really needs is Delivering what the customer wants, when for dinner. The inexorable moves to map scope. The more products and services that she wants it, at a price she is willing to pay is and fill a customer’s daily needs mean that consumers can find under one roof, and the ultimate value proposition. Amazon is becoming increasingly central the more easily consumers can access these But there are three things that Amazon to the consumer’s experience, as much as services, the more benefits consumers will needs in order to deliver the three s’s. it is becoming more customer-centric in see and accrue by engaging with Amazon. First and foremost, it needs data, both everything it does. This idea of occupying But customers will not be attracted external and internal. External data include “adjacencies”—meeting customer needs to Amazon if they find prices too high, information from Amazon’s own customer proximal to those that you currently ful- which is where scale and efficiency come base and the customer bases that come fill—has been a pillar of marketing practice in. Having access to a very large customer in via acquired companies. It can mean

for a long time. Amazon, for its part, has base allows Amazon to obtain favorable data from the marketplace, which includes DANIELLA DELUNA GTYSSLER,BY GLEN DESIGN PRODUCTION BY PHOTO

54 Chicago Booth Review Winter 2017/18 competitors and companies with other offer a wide range of products online was business models and innovations. Amazon The inexorable made possible by bringing third-party also needs internal data. How are the moves to map and sellers onto Amazon’s platform. These internal processes doing? Where can they sellers provide mainstream products, be improved? Are there bottlenecks that ll a customer’s plus they extend the breadth of product can be eliminated? offerings by giving consumers access to Amazon also needs innovation to retain daily needs mean more obscure products (those in the “long and enhance its customer-centricity. This tail” of customer needs). This reinforces could be innovation in product (such as that Amazon the consumer benefit from visiting and Alexa, the voice service that powers the is becoming shopping on the Amazon site. Initial moves Amazon Echo), process (such as delivery at Whole Foods seem to be going against by drone), or content (such as the Amazon increasingly central this notion, however, as the acquired original TV series Fortitude). With company announced a reduced emphasis Amazon facing ever-changing customer to the consumer’s on local suppliers. But Amazon needs needs, the ability to marry data with experience. to nevertheless explore ways in which it innovation will be a key driver of the can better leverage physical locations as company’s future success. local platforms. Lastly, as the company increasingly The idea behind the three s’s, and what moves from the online world to the offline, is needed to support it, bears a strong it needs to think of ways of replicating its resemblance to what Amazon refers platform strategy offline. The ability to to internally as the “flywheel.” In the

Winter 2017/18 Chicago Booth Review 55 traditional strategy literature, organizational The acquisition also gives Amazon “fault lines,” where one activity may require Amazon cannot access to Whole Foods’ private-label skills that are not consistent with those discount the product line 365. Recall the customer’s required for other activities, are associated journey for detergent. The one factor with the organization’s need to manage the possibility that Amazon still has no control over is three s’s. What Amazon has been able to the detergent itself, since detergents are do thus far, and needs to continue to do, is of upsetting manufactured by outside companies. manage effectively across these fault lines. customers as it Because this limits Amazon’s profit margins, the company has increasingly Putting the three s’s into action engages more been launching its own products— Now let’s get back to the original question of AmazonBasics batteries and cords, for why Amazon acquired Whole Foods and, in deeply in example. This own-brand push will be light of the above analysis, examine various significantly enhanced by the 365 line from reasons Amazon provided. their lives. Whole Foods. Many more reasons for the acquisition n One argument is that as grocery purchasing have been advanced, but as should now increasingly migrates online, Amazon will be clear, most of them fit into the broad be able to use its access to Whole Foods to rubric of enhancing Amazon’s scope, scale, fulfill this need. and speed. Indeed, the acquisition also has n Another is that Whole Foods can act as a direct impact on some of the enablers: a distribution hub since it has urban and data, innovation, and platform. suburban locations. Because the locations While growing size, product, and have attractive demographic profiles, service variety are clear advantages with high-earning residents, Amazon can for now, Amazon cannot discount the physically reach its customer base in these possibility of upsetting customers as it areas. In addition, the stores can become engages more deeply in their lives. When showrooms for Amazon products, such as I was recently on the site, trying to buy Alexa, that have been optimized to allow some cranberries, I was met with a dizzying consumers to shop more easily on the array of products and processes including Amazon website. AmazonFresh, Amazon Prime Pantry, n Third, and related, is that as Amazon gets Amazon Prime, and a host of third-party access to the Whole Foods customer base, sellers. These options, plus even more Whole Foods shoppers who are not big unique possible combinations, made me Amazon buyers may be tempted to sign on decide to buy the product elsewhere. with a Prime bundle designed specifically to In the end, I was unable to locate the appeal to them. right combination of product (organic n Fourth, the company will get more out of cranberries in a 3 lb package), process customer data. By combining offline data (Prime), and price—even though I knew that from Whole Foods with online shopping the right combination existed somewhere data, Amazon may be able to further refine in the multitude of search results. the scope of its product offerings. I find there’s typically a movie quote for n Fifth, with its experience in running its every situation—and in this case, a perfect own operations efficiently, Amazon may one comes to mind. Toward the end of The help improve the efficiency of Whole Foods Lincoln Lawyer, the title character, Mick operations. From sourcing and dynamic Haller (played with gusto by Matthew replenishment to dynamic pricing and McConaughey), offers his services for free streamlined store operations, there are to a potential client. His chauffeur, Earl many ways in which the companies may (played by Laurence Mason), overhears this be able to lower costs while enhancing the generous offer and asks, “Are you all right?” overall customer experience. To this Haller replies, “Repeat customers, Earl. We’ll stick it to ’em next time.” As Other reasons: the retail locations can Amazon scoops up customers who become become sites where customers who find more reliant on it, these customers should store returns convenient can return products hope that the company does not behave purchased on Amazon, rather than go to the like Haller and stick it to them down post office or UPS store. Also, the acquisition the line. gives Amazon access to a set of retail employees considered some of the most customer-centric Pradeep K. Chintagunta is Joseph T. and in the business, and who may help Amazon Bernice S. Lewis Distinguished Service better understand ways of enhancing employee Want more on marketing? Professor of Marketing at Chicago Booth. He Visit our website to find past columns, satisfaction at Amazon itself. Ultimately, as many as well as other articles and videos. blogs at kiltscenter.tumblr.com. He thanks marketers have pointed out, the profit chain Booth MBA student Yogesh Kansal for his runs through both employees and customers. feedback and input.

56 Chicago Booth Review Winter 2017/18 before August. Nonetheless, I was left a bit disappointed after reading THE GRUMPY it. She devoted just three paragraphs ECONOMIST to a section entitled “Remaining JOHN H. COCHRANE Challenges,” and yet there are far more questions to be asked, paths to choose, and fundamental choices to be made than could be covered so The real briefl y. With President Donald Trump having nominated Jerome H. Powell to questions the replace Ms. Yellen as chair when her term expires in February, this is an Fed should opportune time to consider them. Which deregulation? ask itself The call from many policy makers, including some within the Trump Don’t mistake relative calm administration, to roll back our in the fi nancial system as a regulatory structure can be read two sign that the central bank’s ways: 1) reduce the insanely complex rules, and the even more intrusive work is done discretionary supervisory regime, designed in a futile attempt to make hen Federal Reserve Chair sure banks never lose money, and Janet Yellen spoke at the replace them with higher capital Fed’s annual monetary standards so that banks’ losses pass policy symposium in Jackson smoothly to shareholders without Hole,W Wyoming, this August, her topic— threatening the economy; or 2) reduce fi nancial stability and the Fed’s role in capital and leverage ratios, keep the fi nancial regulation and supervision—said complex, anticompetitive rules on the a lot. Financial regulation, supervision, books, let banks continue to slowly and direction is much more centrally a capture the discretionary regulators, part of what the Fed is and does these and keep the wink-wink bailout regime days than is standard monetary policy. in place. Let profi ts roll in to the big Whether overnight interest rates go up banks. Until the next crisis. or down a quarter of a percentage point You can guess which one I favor. may be the subject with the greatest ratio I sense Ms. Yellen is mostly pushing of talk to action, and of commentary to back on the second, especially the actual eff ect, in all of economics. (Bottom desire by big banks for less capital line: interest rates in the United States and more trading freedom. But aside are likely to stay around 1 percent for the from acknowledging that “there may foreseeable future. Get used to it.) But be benefi ts to simplifying aspects of the Fed is deeply involved in running the the Volcker Rule . . . and to reviewing fi nancial system, and all the talk points to the interaction of the enhanced it becoming more so. We don’t need supplementary leverage ratio with Rather unsurprisingly, Ms. Yellen risk-based capital requirements,” did not give a speech bemoaning the 10,000 pages of she concludes in her speech that current state of aff airs. She’s been “any adjustments to the regulatory in charge, after all. If she viewed the regulations, or framework should be modest.” Really? Dodd-Frank Act as a grossly complex Is every provision of the Dodd-Frank Rube Goldberg contraption, and the annual stress tests, Act wise? Is there no room, after 10 Fed as only following silly rule-making just to demand years and a lot of experience, for a dictates to comply with the law, she thoughtful evaluation and revision of would have said so loudly, and long more capital. the tens of thousands of pages of rules?

Winter 2017/18 Chicago Booth Review 57 Are we any safer? we can use to gauge safety, and The most important question, really, conceded that each has its flaws. is whether the system is in fact safer, But perhaps their biggest flaw is more resilient, and ready to deal that they have to be interpreted with the next crisis, especially if that and acted upon—at just the right crisis comes from a new source—say time and in just the right way—by pensions, student debt, or worst of policy makers, who have proven all, global sovereign debt. Ms. Yellen spectacularly unequal to this asserts in her speech that, yes, challenge in the past. How much better is Ms. Yellen’s feeling that reforms have boosted the resilience the banking system is safe than was of the financial system. Banks former Fed Chair Ben Bernanke’s are safer. The risk of runs owing similar feeling in 2007, and on to maturity transformation is what basis? More deeply, what reduced. Efforts to enhance the justifies her faith that this time, resolvability of systemic firms have policy makers monitoring “a range promoted market discipline and of supervisory and market-based reduced the problem of too-big- indicators of financial system to-fail. And a system is in place resilience” will see the crisis to more effectively monitor and coming, and do something about address risks that arise outside the it? Ms. Yellen herself acknowledged regulatory perimeter. that those who assembled at Jackson Hole 10 years ago were fairly Really? How and why? sanguine about the stability of the financial system. Loss-absorbing capacity among the The screaming lesson of the last largest banks is significantly higher, crisis ought to be that we need a with Tier 1 common equity capital resilient system, not purportedly more than doubling from early clairvoyant policy makers monitoring— 2009 to now. The annual stress- and, by implication, guiding—the testing exercises in recent years have system. Crises are, by definition, led to improvements in the capital unpredictable. Any regime that relies positions and risk-management on regulators to see it coming is processes among participating doomed to failure. Again. banks. Large banks have cut their reliance on short-term wholesale Regulation or supervision? funding essentially in half and hold An analogy: the highway patrol, the significantly more high-quality, Department of Motor Vehicles, and liquid assets. the Department of Transportation are in charge of highway safety. By Economic research provides further and large they set rules: drive 55 mph support for the notion that reforms here and 35 mph there; stop at red have made the system safer. Studies lights; stay within lane lines. They have demonstrated that higher do not tell us, “Submit your plan to levels of bank capital mitigate the drive to Los Angeles for approval”; risk and adverse effects of financial nor do they put an employee in the crises. Moreover, researchers have back seat to tell you when it’s time to highlighted how liquidity regulation pull over and rest. We tend to call all supports financial stability by of the above activities “regulation,” complementing capital regulation. but “supervision” is a polite word for Practically nobody the latter endeavors. There are many Yes! Capital, capital, capital, impolite words. and the more the merrier. But stops to ask: Just So is the Fed’s job to set up stable we don’t need 10,000 pages of rules of the game, standards such regulations, or annual stress tests, because a central as capital requirements, so that just to demand more capital. The bank can aect the the system is resilient on its own? questions are: Just how much Is it in charge of writing the fire capital should we demand, and how economy through its code, and determining how many should it be measured? sprinklers and extinguishers should Apart from capital regulatory or asset be in each house? Or is the Fed’s job requirements, Yellen made purchase powers, to be the fire department, spotting reference to metrics, both market fires as they break out, rushing to based and “supervisory,” that should it do so? the rescue? Or, should it send its

58 Chicago Booth Review Winter 2017/18 employees to watch over how we cook Are insurance companies systemic? dinner, as its embedded employees If the explanation Are retirement plans systemic? Just who watch the big banks? for the crisis is gets saved when? Central banks are giant discretionary Or to take the other half of the financial regulators, making little all “madness of phrase: What is a crisis? Is it just a distinction between the sit-back-and- bunch of bankruptcies? What is the make-rules versus decree-actions-and- crowds,” there nature of contagion? Is it a domino outcomes approaches. It’s no surprise, effect—Bank A fails, Bank A owes then, that their regulatory, supervisory, is absolutely Bank B money, so Bank B fails? Is it a and policy activities are merging. When nothing in the new run—Bank A fails, so people question a little stimulus is needed, they can Bank B and pull out run-prone assets? just tell banks to lend, or they can use regulatory regime The system seems to handle even big quantitative easing to push up asset bankruptcies fine at some times but prices. If a bubble is diagnosed, they to stop a crisis from not at others. What makes those times can tell banks to cut back, or they can happening again. different? How do you “resolve” a bank tighten regulations, or they can sell during a crisis? some assets. Ms. Yellen points to liquidity being Hundreds of academic papers find a problem in a crisis, and her Fed that central banks can affect this or now encourages institutions to have that by buying securities, changing lots of liquid assets to sell in the event bank regulations, changing financial of losses. But sell to whom? Isn’t regulations, and so on. Then they segue there something deeply wrong about into policy conclusions on how central a system in which everyone’s risk- banks should use these dandy new management plan is to sell assets in the tools. Practically nobody stops to ask: event of price declines? Just because a central bank can affect Ms. Yellen’s account of the 2007–10 the economy through its regulatory financial crisis, as presented in her or asset purchase powers, should it do Jackson Hole speech, is largely a so? The question, “Do we really want familiar story of behavioral excess (by an independent central bank routinely market participants and regulators), dialing up and down levers of cash-out with no mention of mechanics. Yet the refinancing, with an eye to raising or Fed chair’s job is to fix the machine, lowering stimulus?” just never occurs not to wish for smarter people. If the to anyone. explanation for the crisis is all “madness That constitutional question is the big of crowds,” there is absolutely nothing one we all should be asking as central in the new regulatory regime to stop a banks move to financial regulation and crisis from happening again. discretionary supervision. I have a view on this. The crisis was a run—and not one of the other stories. What’s systemic anyway? Runs are by definition unpredictable. Just what do we mean by a “systemic” The essence of a run is not the riskiness crisis? That would seem to be a or illiquidity of bank assets; it is the run- foundational question that a Fed chair prone nature of bank liabilities. We can should weigh in on, yet the answer is set up our financial system so that it will decidedly muddy. never again have a crisis by insisting It bears on policy. For example, right banks fund themselves with run-proof now there is a movement around the liabilities, predominantly common world to declare that asset managers are equity, and isolate any needed leverage systemic dangers. How is that possible? outside the banking system. Such a The manager buys and sells your stocks. system requires an order of magnitude If he or she invests in a stock and it goes less regulation, and two orders less down, you can’t demand your money supervision. Well, I don’t run the Fed. back, you can’t run, and you can’t force But those who do desperately need the manager into bankruptcy. Shouldn’t clear answers to these questions, asset managers get a nonsystemic and a clear vision of the Fed’s role in gold star, for not issuing run-prone managing the financial system. securities? Well—the story goes—they might “herd” or be prone to behavioral John H. Cochrane is a senior fellow biases, and, heaven forbid, sell stocks, of the Hoover Institution at Stanford which might, heaven forbid, go down. University and distinguished senior fellow “Financial stability” now seems to mean at Chicago Booth. This essay is adapted nobody should ever sell anything, and from a post on his blog, The Grumpy stocks should never go down. Economist.

Winter 2017/18 Chicago Booth Review 59 60 Chicago Booth Review Winter 2017/18 ILLUSTRATION BY EDMON DE HARO corner for precisely the wine-related IN-HOUSE reason Francis dismisses. Such gifts were ETHICIST liable to do more harm than good, he told JOHN PAUL us, and we were better advised to fi ll the ROLLERT collection plate or favor some charity. The notion that handouts could be counterproductive to charitable ends What’s the is hardly a peculiar opinion today, but the logic supporting it has a fairly recent vintage. In the West, until just a few matter with hundred years ago, helping the less fortunate was a fairly straightforward handouts? process. Consider how the King James How charitable giving became Bible describes evidence of the “blessed”: about endowments and museum For I was an hungred, and ye gave me wings, not spare change meat: I was thirsty, and ye gave me drink: I was a stranger, and ye took me in: Naked, he topic of redistributing wealth and ye clothed me: I was sick, and ye has a tendency to short-circuit visited me: I was in prison, and ye came dates, spoil Thanksgiving unto me. dinners, and occasionally sever Tfriendships—unless the redistribution in Beyond the comforts aff orded by question is charitable giving. When the human contact, the help that might haves give freely to the have-nots, most be provided the “least” among us is people see it as an example of enlightened almsgiving, off ering money or other aid self-interest and therefore a cause for directly to the poor. Such assistance is the celebration, not complaint. most ancient of philanthropic exercises. Still, not all benefactions are created That it is no longer the most venerable equal, and, for many, the least among as well says a lot about how the ethics of them may be giving money directly to the charity have changed over time. poor. Indeed, handouts have fallen into such disrepute that Pope Francis himself Cotton Mather’s view of charity felt the need to defend them. “Help is This evolution was anticipated by Cotton always right,” he told a Milanese street Mather, the Puritan minister of colonial magazine, Scarp de’ tenis, in February. But Boston who articulated an approach to what if I give a beggar a few bucks, and he charity that was so unorthodox in spirit spends it on a glass of wine? “If a glass of as to seem slightly heretical. Refl ecting wine is the only happiness he has in life,” on what prevented us from undertaking the pontiff mused, “that is fi ne.” charitable endeavors, Mather regarded a Throughout the interview, Francis failure of will as the chief impediment. The seems less concerned about vindicating tendency to be idle, even in the face of great a particular kind of gift than vitiating need, was “the most concealed, and yet the the reticence to give, but as a counter to most violent of all our passions,” Mather conventional wisdom about charitable wrote in Bonifacius, or Essays to Do Good. giving, his reply is remarkable nonetheless. Such “baneful Thoughts” needed to “be Maintaining a scrupulous inhibition about chased out of our Minds” to make room for handing out money to panhandlers isn’t the “Subject, ‘What Good may I do?’” the exclusive domain of prigs and penny- The concern that laziness might pinchers. Even my father, whose politics undermine our charitable instincts is and leonine hairline can occasionally make largely unobjectionable, but Mather made him seem like a Catholic Che Guevara, the more radical and contentious move discouraged my sisters and me from to apply the same logic to charitable acts dispensing spare change on the street themselves. Benefactors should always

ILLUSTRATION BY EDMON DE HARO Winter 2017/18 Chicago Booth Review 61 keep an eye on the “spiritual interests” from the formation of what would of the intended recipients, he advised, As much as become the University of Pennsylvania, and “[i]f there be any idle persons to the establishment of the city’s first among them, endeavor to cure them anyone else in the lending library and public hospital, of their idleness: do not nourish and early American to the organization of a subscription harden them in it, but find employment program to employ street sweepers. for them” and “then be otherwise as experience, “Some may think these trifling Matters bountiful to them as you please.” not worth minding or relating,” he Pursuing a “cure” for idleness is a Benjamin Franklin writes, acknowledging that he’s testing tricky business, particularly when the the patience of his readers. And yet, he Bible rules out the threat of starvation or shifted the continues, “Human Felicity is produc’d death by exposure. The effort also raises not so much by great Pieces of good delicate questions about who constitutes organizing logic Fortune that seldom happen, as by little the worthy poor, a novel denomination of charitable Advantages that occur every Day.” and one that seemed a tad insidious The implied lesson was that the good to many of Mather’s peers. Given his activities from person did not wait around for grand enthusiasm for the Salem witch trials, an opportunities to make his philanthropic extracurricular commitment that cost “help” to “self-help.” mark. He seized every chance, large him the presidency of Harvard, Mather’s and small, to improve his community, moral compass was already regarded showing himself less concerned about as slightly unreliable by members of bragging rights than common benefit. the Massachusetts Bay Colony, and he Franklin’s life and work make chafed at what he called the “reproaches it clear why he and Mather are of those soft-hearted or warm-blooded credited with helping to inspire the philanthropists” who “applaud as volunteeristic spirit that so decidedly the only true lovers of their species” shaped the colonial experience, and people who are “equally unthinking yet “the First American” (as Franklin and indiscriminate in almsdeeds.” was nicknamed) went far beyond his They “stigmatise us” as “enemies of the illustrious forerunner by omitting the poor,” he said, because we “sometimes ameliorative role of almsgiving from withhold” alms from the indigent, his charitable regimen. Whenever he hoping to have the effect of “quickening discusses doing good, Franklin’s focus their own industry.” is always organizational in nature, his philanthropy programmatic. He didn’t Ben Franklin weighs in emphasize the necessitous individual, That the withholding of charity might but the needs of what one admirer itself be a charitable act proved an called “a rising people.” unlikely but enduring contribution These two sets of commitments are to philanthropic theory, yet it wasn’t certainly not at odds. They aren’t even the only legacy of Mather’s Essays inconsistent. One can endow soup to Do Good. In his autobiography, kitchens and philosophical societies Benjamin Franklin highlighted the without any cognitive dissonance. But influence of Mather’s book, together like Mather before him, Franklin viewed with Daniel Defoe’s An Essay upon traditional almsgiving with skepticism, Projects, for championing the support worried that efforts to remedy the of significant public initiatives that immediate pangs of poverty might improved the moral and social welfare interfere with the “cure” for idleness. of a community. “[W]hat is done for Franklin’s solution was a variation on Schools, and for Colleges, and for his lesson of “Human Felicity” and the Hospitals, is done for the general good,” “little Advantages” that support it. “If Mather had written. “The endowment you teach a poor young man to shave or maintenance of these is at once to do himself and keep his Razor in order,” good unto many.” he wrote, “you may contribute more to As Franklin made his way from the Happiness of his Life than in giving penniless apprentice to the most famous him 1000 Guineas. The Money may be man in America, he took great pride in soon spent, the Regret only remaining of cultivating what he called the “projecting having foolishly consum’d it.” public spirit” that saw him lend his intellectual, organizational, and financial More from John Paul Rollert Andrew Carnegie’s tougher stance assistance to a host of programs in and As much as anyone else in the early around his adopted city of Philadelphia. Visit our website to read other articles American experience, Franklin shifted Franklin chronicled these efforts at by this author. the organizing logic of charitable length in his autobiography—everything activities from “help” to “self-help.”

62 Chicago Booth Review Winter 2017/18 At the same time, he contributed to the men of the race.” As Carnegie interpreted not synonymous with the rich and the growing suspicion that a handout and his own life, such efforts had been made poor—that, unlike the aristocratic realm he a hand-up were mutually exclusive. on his behalf. He arrived in America when left behind in Scotland, merit, rather than The philanthropically inclined had to he was only 12 years old and immediately inherited money, made all the difference in choose, and Andrew Carnegie, nearly a went to work in a Pittsburgh cotton factory who succeeded. century later, had no difficulty making for $1.20 a week. Having almost no formal his decision. education, he forever regarded as his Lessons for modern philanthropy “It were better for mankind that the first patron Colonel James Anderson, a But what should be done for those who millions of the rich were thrown into the local gentleman who made his personal fail? For the meritocrat with charitable sea than so spent as to encourage the library available to “working boys” on the intentions, this is a thornier matter. slothful, the drunken, the unworthy,” the weekends. “Only he who has longed as I Consider the boot-strapping maxim, steel magnate wrote. “Of every thousand did for Saturdays to come can understand “If you give a man a fish, you feed him dollars spent in so-called charity to-day, what Colonel Anderson did for me and the for a day. If you teach a man to fish, it is probable that $950 is unwisely spent; boys of Allegheny,” Carnegie later said. “Is you feed him for a lifetime.” Like most so spent, indeed, as to produce the it any wonder that I resolved if ever surplus platitudes, this one is comforting but also very evils which it proposes to mitigate wealth came to me, I would use it imitating incomplete. You can’t teach someone to or cure.” my benefactor?” fish who doesn’t already have a fishing Carnegie’s broadside against “indis- It is a wonderful sentiment but worthy pole, and if you go ahead and hand out 10 criminate charity” came in “The Gospel of the disclaimer that not everyone can poles to 10 men, for every one who lands of Wealth,” an 1889 essay in which he imitate Andrew Carnegie, certainly not a leviathan, another will lose his pole, addressed the precarious social conditions in all of the ways that made him one of one will break it, and three will still come his own success had helped exacerbate. the most remarkable men of his era. home empty-handed. Describing the “concentration of business” Carnegie understood this. You cannot be What to make of these misadventures, in “the hands of the few” as a hallmark of the unapologetic social Darwinist he was to say nothing of the man who sleeps in advanced capitalism, Carnegie admitted that unless you acknowledge that the strong and doesn’t fish at all, is not a problem this development had fostered antagonism and weak will inevitably be among us. for the older vision of charity, which and mutual distrust. “The problem of our The aim of his philanthropic “Gospel” was simply demands evidence of need. But age is the proper administration of wealth,” simply to ensure that this distinction was the disposition toward the poor that was he wrote, “so that the ties of brotherhood anticipated by Mather and Franklin and may still bind together the rich and poor in acclaimed by Carnegie is more ambivalent. harmonious relationship.” At its best, it indulges the temptation to Among other things, such an assertion look upon the less capable with a spirit assumes that free markets won’t of benign paternalism—a tendency that mend this relationship, and that the can manifest itself in a reticence to offer redistribution of wealth is necessary. alms but also, in what might seem like a Searching for a solution that would worthier form of redistribution, to pay the preserve individual prerogative, Carnegie poorest workers higher wages. (Carnegie took his cue from Franklin’s “projecting himself issued the unctuous warning that public spirit,” widening its scope to You can’t teach if great wealth were “distributed in small accommodate the philanthropic abilities sums” to laborers, it would largely be of the wealthiest men in America. To someone to sh “wasted in the indulgence of appetite.”) At them, Carnegie extolled “benefactions worst, however, this spirit of contemporary from which the masses of their fellows who doesn’t already charity favors a tone that can seem almost will derive lasting advantage,” a universe pitiless, at times, exchanging the sentiment of charitable largesse that included the have a shing pole, “there but for the grace of God” in the face endowment of colleges, libraries, and of the poor for a healthy, even righteous, concert halls, “the ladders upon which and if you go ahead disdain of failure. the aspiring can rise.” At the same time, Pope Francis seemed to have this he did not so much eschew as shunt and hand out 10 sentiment in mind in his February aside the traditional form of charitable poles to 10 men, interview. “It is possible to see a homeless assistance. “Neither the individual nor person and look at him as a person, or as if the race is improved by alms-giving,” for every one who he were a dog,” he said. For those in need, Carnegie maintained. “Those worthy of a helping hand, in any form, is preferable assistance, except in rare cases, seldom lands a leviathan, to a tight fist, but the deed loses something require assistance.” of its luster if, instead of a gesture of As such declarations attest, the another will lose solidarity and warm encouragement, ultimate aim of philanthropy, in it more closely resembles the way we Carnegie’s view, was not to assist the his pole, one will redistribute scraps to dogs under the poor by binding up their wounds and break it, and three dinner table. offering some small measure of human comfort. It was to grease the gears of will still come home John Paul Rollert is adjunct assistant meritocracy and make ample room professor of behavioral science at among the elite for the “really valuable empty-handed. Chicago Booth.

Winter 2017/18 Chicago Booth Review 63 It’s time to rethink Milton Friedman’s ‘shareholder value’ argument

While agreeing with Friedman’s premise Friedman recognized that in some cases that managers should care only about shareholders may have diff erent objectives, shareholders’ interests, Nobel Laureate but he concluded these objectives are ASHER Oliver Hart of Harvard and Chicago better pursued by the shareholders on SCHECHTER Booth’s Luigi Zingales reject the view that their own. This is certainly the case for shareholders care only about money. Friedman’s leading example: corporate A company’s ultimate shareholders are charity. Ignoring tax considerations, Where Friedman ordinary people who, in addition to caring according to Friedman, it is preferable that was wrong about money, are also concerned about the money spent in corporate philanthropy a myriad of ethical and social issues: they be paid out to shareholders in the form of n 1970, the late Milton Friedman of purchase electric cars to lower their carbon dividends and then allocated by them to the University of Chicago famously footprint; they buy free-range chicken or charity, rather than allocated by corporate argued that corporate managers fair-trade coff ee because they view this as managers directly. should “conduct the business in the ethical—albeit more expensive—choice. Hart and Zingales argue that this Iaccordance with [shareholders’] desires, They are, in other words, prosocial in their conclusion holds only under the which generally will be to make as much day-to-day life—at least to some extent. assumption that shareholders can money as possible while conforming to “If consumers and owners of private individually reproduce or undo any the basic rules of the society, both those companies take social factors into account corporate decision, without incurring any embodied in law and those embodied in and internalize externalities in their own additional cost. This assumption holds ethical custom.” behavior, why would they not want the for charity: a dollar in charity is the same Since then, Friedman’s view that the public companies they invest in to do the whether it is donated by an individual or by sole social responsibility of the fi rm is to same?” Hart and Zingales ask. a corporation. But it does not hold for most maximize profi ts—leaving ethical questions other social objectives: an individual cannot to individuals and governments—has generally undo corporate pollution at the become dominant in both fi nance and law. same cost that a company would have paid It also laid the intellectual foundations The view that the to avoid it. In this more general case, Hart for the “shareholder value” revolution of and Zingales conclude that a company’s the 1980s. social responsibility objective should be the maximization of Friedman’s position has been attacked of the rm is to shareholders’ welfare, not value. by many critics on the grounds that corporate boards should consider other maximize pro ts Asher Schechter is a writer and editor of stakeholders in their decisions. Yet, if the ProMarket, the blog of Chicago Booth’s owner of a privately held fi rm is under no has become George J. Stigler Center for the Study of the obligation to care about anybody’s interest dominant in both Economy and the State. This is an excerpt but her own, why should it be diff erent for of a post that fi rst appeared on the blog, at a publicly traded company? nance and law. ProMarket.org. KENZIE JOHN BY ILLUSTRATION

64 Chicago Booth Review Winter 2017/18 charity). There is no loss of effi ciency in letting shareholders decide which charities should be fi nanced. Under this restrictive assumption, Friedman’s conclusion is right. In the more general case—where, for example, undoing pollution is more expensive than curbing it to begin with— Friedman’s conclusion does not follow logically. In this respect, Friedman was wrong. Hence, the legitimacy of the title. We admire Friedman and we have no desire to prove him wrong. What we do want is to correct a diff use and consequential mistake that is generally made in teaching fi nance. We looked at the fi ve most cited corporate fi nance textbooks. Four explicitly mention shareholder value maximization as an objective. None mentions shareholder welfare maximization. More importantly, we want to correct the mistake that our teaching has produced as to the way public corporations are OLIVER HART LUIGI ZINGALES run. The fi gure (see “Profi t-minded philosophy,” this page) shows the as much money as possible.” The “generally” percentage of Dow Jones Industrial A small step for indicates that he recognizes that shareholders Average companies that mention value theory, a leap sometimes have other objectives. Yet, maximization as an objective: Friedman’s Friedman concludes that “there is one and rule and MBA teaching had some impact forward in only one social responsibility of business—to on business practices. It was on the use its resources and engage in activities basis of this principle that the board of governance designed to increase its profi ts.” Wal-Mart opposed the inclusion in the Friedman can conclude this because he proxy ballot of a shareholders’ proposal ince we published our recent has in mind a world where social activity aimed at reconsidering the sale of high- paper, we have received criticism and profi t-making activity are completely capacity magazines, the ones used in of the interpretation published independent (as is the case for corporate mass shootings. It is on the basis of the on the ProMarket blog. One shareholder-value principle that corporate Swriter claims that the title of the post boards and courts of law reject the ability of (“Where Friedman was wrong”) is Profi t-minded philosophy shareholders to infl uence corporate policy misleading. His argument is based on The s saw a spike in more exclusively on important issues that shareholders care the fact that Friedman was well aware bottom-line-oriented business practices. about. Moving from shareholder value that “human beings maximize utility, not maximization to shareholder welfare Dow Jones Index companies that mention income” and that people considering value maximization as an objective maximization may be a small step in this discussion “are still saying that theory, but it could trigger a leap forward in shareholder interests come fi rst and only 36% the way our corporations are run. for a company; [they’re] just agreeing, 33% as Friedman would, that those interests Oliver Hart is Andrew E. Furer Professor are shareholder utility, not money of Economics at Harvard University. Luigi exclusively.” Zingales is Robert C. McCormack Distinguished We feel obliged to intervene and clarify. Service Professor of Entrepreneurship and We agree that Friedman believed that 7% 7% 7% Finance and Charles M. Harper Faculty Fellow people maximize utility, not income. In at Chicago Booth. Their response also appeared fact, in his 1970 article in the New York on ProMarket. Times Magazine, he writes that the desire 1960 1970 1980 1990 2000 Go to Review.ChicagoBooth.edu to see citations for of shareholders “generally will be to make Hart and Zingales, 2017 research in this article.

Winter 2017/18 Chicago Booth Review 65 while it may be indisputable that superstar fi rms have been a force for technological and economic progress, there is a creeping concern that their growing dominance could stifl e innovation and progress in the RAM SHIVAKUMAR years ahead. When he fi rst explored the “economics of superstars” (both a description of his The market idea and the title of his paper) 36 years ago, Rosen argued that modern technologies power of would make it possible for the superstar performers in any industry to greatly ‘superstar’ expand the scope of their market while reducing market opportunities for everyone else. Winners would take all (or take most) companies is of the value created. The technological advantages that Rosen presciently described growing were in the costs of replication, search, and delivery. Digitization has reduced Like the wealthiest households, the incremental cost of replication and delivery to virtually zero, and specialized the most successful companies intermediaries such as Google, YouTube, are exerting outsized infl uence Amazon, and Alibaba have made it easier to on the economy fi nd what one is looking for at great speed and at very low cost. ince the 2007–10 fi nancial crisis, More than 30 years after the publication many writers have attempted to of Rosen’s paper, academic literature is document and analyze the growing illuminating how superstars aff ect the inequality among households in rest of the economy. The empirical data Sthe United States and elsewhere. Thomas presented in several papers of recent years Piketty’s Capital in the Twenty-First Century, have helped answer a series of important Matt Taibbi’s The Divide: American Injustice questions, including how much economic in the Age of the Wealth Gap, and Joseph E. power superstar fi rms command, where Stiglitz’s The Price of Inequality: How Today’s their advantages come from, and what role Divided Society Endangers Our Future were they play (if any) in exacerbating income all New York Times best sellers. inequality across households. No equivalent literary subgenre has emerged to examine a related and similarly Superstar fi rms have acquired market important sort of inequality: the growing Superstar rms power in all sectors of the economy dominance of industries and economies by have proven to be For most of the 20th century, the US superstar fi rms, and the implications of this economy was dominated by fi rms with dominance for technological, social, and especially adept “scale and scope,” to borrow a phrase economic progress. from the late business historian Alfred “Superstar,” an idea fi rst applied to at exploiting the Chandler of Harvard—companies such as companies by the late University of Chicago General Electric and General Motors. In economist Sherwin Rosen, is an especially killer combination 1990, however, two management gurus, apt term for organizations such as Apple, of demand- the late C. K. Prahalad of the University Google, Facebook, Amazon, and Microsoft, of Michigan and London Business with whom nearly everyone is familiar and side network School’s Gary Hamel, asserted that the upon which many of us rely on a daily basis. era of conglomerates was over. Size, they These companies and others like them have externalities proclaimed, would cede advantage to helped to engineer dramatic changes in and supply-side agility and entrepreneurship. As Prahalad the way residents of developed countries and Hamel’s mantra of core competencies live, work, communicate, and socialize. But economies of scale. spread, large fi rms such as AT&T, GTE, and

66 Chicago Booth Review Winter 2017/18 ILLUSTRATION BY THE PROJECT TWINS WinterSeason 2017/18 2016 Chicago Booth Review 67 NEC were broken up and hundreds of firms Importantly, superstar companies excel across the world were privatized. Superstars have in their use of the structured and creative Twenty-seven years later, size is back. management/organizational practices that According to the McKinsey Global Institute, the gumption to large and complex projects require. 10 percent of the world’s listed firms generate make the moon-shot In 2010, the US Census Bureau 80 percent of all global profits. Firms with at conducted its first Management and least $1 billion in revenue now account for investments that Organizational Practices Survey. Nearly 60 percent of total global revenue and 65 40,000 manufacturing establishments percent of market capitalization. The pursuit even modern-day participated in MOPS, which used of size has led to a rapid increase in mergers governments are 36 multiple-choice questions to poll and acquisitions: according to the Institute for businesses on their management practices Mergers, Acquisitions and Alliances website, loath to make. (processes for setting targets, monitoring the number of deals grew from 26,845 in 1997 performance, and providing incentives), (with a value of $1.83 trillion) to 48,825 in 2016 organizational practices (structure, span (with a value of $3.62 trillion). of control, and the use of information), The standard metric of monopoly power and basic characteristics (the number of is the concentration ratio, or the share of the managers and nonmanagers, educational market accruing to the top four (or 20) firms. attainment of managers, and union In a 2017 paper, MIT’s David Autor, Christina participation). Patterson, and John Van Reenen, along Stanford’s Nicholas Bloom, MIT’s Erik with University of Zurich’s David Dorn and Brynjolfsson and Van Reenen, Lucia Harvard’s Lawrence F. Katz, compute the Foster and Ron Jarmin of the US Census four- and 20-firm concentration ratios for six Bureau, and Tel Aviv University’s Itay sectors of the US economy: manufacturing, Saporta-Eksten analyzed this data set by wholesale trade, retail trade, services, constructing an aggregate score for each finance, and utilities and transportation, manufacturer’s answer to the 36 questions for 1982–2012. Together, the six sectors (normalized to a 0–1 scale). As their results account for 676 industries, nearly 4 million demonstrate, there is enormous dispersion companies, and 80 percent of total private- in the quality of management and sector employment. organizational practices across US firms. Autor and his coauthors find that the Only 18 percent of establishments four- and 20-firm concentration ratios have employed at least 75 percent of the been trending upward in all sectors—and in structured management practices some of them, quite sharply upward. The included in the survey, while 27 percent four-firm concentration ratio increased by of establishments adopted less than 50 approximately 15 percentage points (in other percent. The superstar firms that received words, it doubled) in retail trade and by the highest scores on the adoption more than 10 percentage points of structured management practices in finance. significantly outperformed those with Crucially, the upward trend in lower scores. Even small improvements in concentration ratios is more evident management led to significant increases in for sales revenue than for employment. profits and firm valuation. Superstar firms are generating more sales revenue without increasing their employee Superstar firms are frugal in their use base by much. of labor In 1990, GM, Ford, and Chrysler had Superstar firms derive substantial combined annual revenues of $250 billion, advantages from their management and a combined market capitalization of $36 organizational practices billion, and an employee base of 1.2 million. Superstar firms have proven to be especially In 2016, the five tech superstars—Google, adept at exploiting the killer combination of Apple, Amazon, Facebook, and Microsoft— demand-side network externalities—those cumulatively had annual revenues of $559 forces that make a product or service’s billion, a market capitalization of more consumer appeal increase as its user base than $2 trillion, and an employee base grows—and supply-side economies of of 660,500. scale. Apple has a 20 percent share of the Jae Song of the Social Security smartphone market but captures as much Administration, Stanford’s Bloom, David as 92 percent of the industry’s operating J. Price of Princeton, Fatih Guvenen of profit. Google processes 3.5 billion searches Want more on concentration? the University of Minnesota, and Till von each day and Facebook has 1.32 billion Wachter of University of California at Los active users each day; together they take in, Read more on this subject at Review. Angeles estimate that about one-third of according to some estimates, as much as 60 ChicagoBooth.edu. the growth in income inequality across US percent of all digital advertising revenue. households since 1980 can be explained

68 Chicago Booth Review Winter 2017/18 by the compensation gap between If one market plenty of evidence that they do, even in employees at the superstar firms and their relatively well-functioning democracies, counterparts working elsewhere. participant reaches through lobbying, media influence, This kind of sway over aggregate political contributions, and other income trends brings us back to the an unassailable means—their power could still work in enormous economic and financial power opposition to a healthy economy. The that superstar companies wield today. That point of power, it can bigger a company is, the more easily it can power can be, and often is, put to excellent create distortions gobble up nascent competitors, or take use: these companies have the gumption anticompetitive measures against them— to make the moon-shot investments that that make everyone for instance, starving them by driving up even modern-day governments are loath to the cost of materials. Low prices, high make. They have the organizational ability worse o. wages, and high-quality goods and services to mobilize resources from around the are the product of competition between world at warp speed and the management healthy rivals; if one market participant skills to coordinate complex projects. But reaches an unassailable point of power, it they also have the incentive and the power can create distortions that make everyone to thwart competition and influence the worse off. rules of the game. None of which is to say that we actually As Chicago Booth’s Luigi Zingales has are worse off, collectively, as a result of noted, only eight countries in the world today’s superstars. Virtually everyone have national governments that generate as understands that Facebook, Google, much revenue as Wal-Mart does. The largest Amazon, and other powerful firms have corporations command resources—money made enormous contributions to our and manpower—that make them more than contemporary quality of life. But the value a match for virtually any governmental of these contributions shouldn’t blind agency, let alone their smaller competitors, us to the dangers posed by the power consumer advocacy groups, or other modern superstars have accumulated. organizations whose aims may run counter to these corporations’ pursuit of increased Ram Shivakumar is adjunct professor of profits and market share. economics and strategy at Chicago Booth.

Even if superstars exerted no direct Go to Review.ChicagoBooth.edu to see citations for inﬂuence on government—and there is research in this article. ILLUSTRATION BY THE PROJECT TWINSPROJECT THE BY ILLUSTRATION

Winter 2017/18 Chicago Booth Review 69 FROMTHEARCHIVES

1950 1960 1970 1980 1990 2000 2010

The long-running Selected Papers series features notable work by University of Chicago faculty and other business leaders. This essay is an edited excerpt; the original was presented in 1974 to the 34th group of the Executive MBA Program at Chicago Booth.

candals in the United States, underlings, but with personages who Watergate and not least political scandals, once held the governance of the nation have usually been short-term in their soiled hands. It is different affairs. In most such instances, because the essence of the wrongdoing is and Sthe press publishes the charges of not to be found in the greed for money. wrongdoing with its accustomed fervent, It is different because it raises important if not noisome, self-righteousness. The constitutional questions, not least of presidential accused is quickly condemned by the which is, as President Nixon constantly public, often removed from office, and reminds us, the question of the proper power in soon forgotten, or else left to the long- status of the presidency itself in our drawn processes of the criminal law. constitutional democracy. Not the XYZ In the latter event, the press coverage affair (a diplomatic scandal of the 18th America will be intense and titillating during century), not the corruption of the the period of the trial, but also soon Grant administration, not the Teapot The scandal reflected two beyond the interest of the American Dome scandal of the 1920s, not all of kinds of corruption public. Seldom do the cases involve them together cut so deep a wound in more than the peccadilloes of a single, the American body politic. Even so, the BY PHILIP B. KURLAND temporarily high-placed official; seldom immediate events of Watergate are not do the cases present basic problems of so threatening to our democracy as the a constitutional nature. The Watergate more fundamental ailment of which What’s old is new affair is different. It is different because Watergate is only a symptom. In his Visit Review.ChicagoBooth.edu to read the immediate criminal acts are but recent tour de force (1973’s The Imperial more from Selected Papers through symptoms of a deeper and more Presidency), in some ways an apologia the decades. fundamental ailment. It is different pro vita sua, Arthur Schlesinger noted

because it is not concerned with the terminal illness that threatens us: KENZIE JOHN BY ILLUSTRATION

70 Chicago Booth Review Winter 2017/18 For Watergate was a symptom, not a the Watergate scandal? Is it improper to our democratic institutions cause. Nixon’s supporters complained that suggest that Truman’s Korean venture is than those indulged by the Nixon his critics were blowing up a petty incident the direct precedent for the illegal war campaign forces? out of all proportion to its importance. initiated by President Kennedy, stepped Watergate, however you define it, is No doubt a burglary at Democratic up by President Johnson, and continued a modern day Pandora’s box. The evils Headquarters was trivial next to a mission to a delayed end by President Nixon? it has loosed are immeasurable. The to Peking. But Watergate’s importance Is it bad taste to assert that the secret problems it has raised are horrifying was not simply in itself. Its importance bombings of Cambodia were no more and apparently unsolvable. There are was in the way it brought to the surface, secret than the original use of advisors in two different kinds of constitutional symbolized, and made politically Vietnam or the use of CIA mercenaries in questions that derive from Watergate. accessible the great question posed Southeast Asia at an earlier date? The first are those constitutional issues by the Nixon administration in every For me, all these questions and more that have engaged the attention of the sector—the question of presidential power. are necessary to the understanding of news media and the public. Essentially The unwarranted and unprecedented Watergate. Watergate did not occur as these constitutional matters derive expansion of presidential power, because a biological sport. It is not a matter of from questions of who is guilty of it ran through the whole Nixon system, yesterday, but of many yesterdays. Did what, of how guilt is to be determined, was bound, if repressed at one point, to money play a different role in the 1972 and on what evidence. This kind of break out in another. This, not Watergate, campaign than in the 1960 Democratic question has been, or probably will be, was the central issue. primaries and the contest that followed? resolved by some appropriate tribunal. Were the tactics that secured the The second set of constitutional Clearly, Schlesinger is right in his nomination for the Democratic candidate questions is more important, if analysis. But, possibly because he was an in 1972, a candidacy that assured a less sensational and therefore less agent of earlier administrations, he did Republican victory, more wholesome for noticed. These are concerned with the not see that the disease was contracted conditions that have made Watergate before Nixon came to power. The power possible, i.e., with the present structure of arrogance, the cancer that could kill of our government and the problem of our republic, was fully impregnated by the the survival of our democracy. These Kennedy administration, grew under the questions are likely to remain obscure Johnson administration, and only achieved and unresolved for want of attention its culmination under Nixon. or a proper forum, and with the great possibility of dire consequences. The context for the crisis Watergate is not a place, not a series Washington’s vision of recent events, not a point in time. George Washington’s decision not to be Watergate is a compendium whose most available for a third term as president important element is a state of mind, an of the US was announced in what we attitude about how American government have all come to know as his Farewell should function. Watergate is also a Address. Every American schoolboy question whether these United States can knows of the Farewell Address. And survive as a constitutional democracy. yet, it must be conceded that none of Is it erroneous to suggest that the the advice so painstakingly offered in immediate events of Watergate began the address has been abided. with the Pentagon Papers leak? Is it Washington warned against heresy to suggest that the evils that were political parties, and they have come revealed by the Pentagon Papers were to dominate American affairs. He wrongdoings of presidents Kennedy advised against “overgrown military and Johnson and their advisors rather Watergate brought establishments which, under any form than those of President Nixon and his of government, are inauspicious to advisors? Is it inappropriate to notice the specter of liberty, and which are now regarded that the “Plumbers” were President as particularly hostile to republican Nixon’s contribution to the scandals of totalitarianism to liberty.” He admonished us that “it will the Pentagon Papers? Is it irrelevant to the attention of the be worthy of a free, enlightened, and at notice that the Bay of Pigs and the Central no distant period a great nation to give Intelligence Agency are integral parts of American public. to mankind the magnanimous and too

Winter 2017/18 Chicago Booth Review 71 FROMTHEARCHIVES novel example of a people always guided I, it has always brought with it exaltation The modern American Presidency can by an exalted justice and benevolence.” of executive authority. And each time, be compared with the British monarchy Included among his cautions was one until the advent of the Vietnam War, as it existed for a century or more after that is particularly relevant to the subject this concentration of authority has been the signing of the Magna Carta in 1215. of our discussion today. In 1796, he told us: justified not only by our leading liberal . . . Indeed, it can be said that the main politicians but also by our leading liberal difference between the modern American It is important . . . that the habits of scholars, either on the ground of necessity President and a medieval monarch is thinking in a free country should inspire or expediency. that there has been a steady increase caution in those entrusted with its Since Roosevelt’s tenure, all meaningful rather than a diminution of his power. In administration to confine themselves government power has been vested comparative historical terms the United within their respective spheres, in the national government. The only States has been moving steadily backward. avoiding in the exercise of the powers governmental powers that states now of one department to encroach upon exercise are those allowed to them by the The point I should like to make here, another. The spirit of encroachment national government. State government however, is that the dangers to American tends to consolidate the powers of all is politically as well as economically democracy and freedom against which departments in one, and this to create, bankrupt. And, within the national George Washington warned lie not only in whatever the form of government, a real government, power has, since Roosevelt’s the adhesion of power to a single man, the despotism. . . . If in the opinion of the day, been concentrated in the executive president, but the adhesion of power to the people the distribution or modification branch. This is not a result of the Nixon executive office: an executive office that of the constitutional powers be in any incumbency. includes the National Security Council, the particular wrong, let it be corrected by As long ago as 1968, before Richard Council of Economic Advisers, the CIA, an amendment in the way in which the Nixon was elected to his first term as and the Office of Management and Budget Constitution designates. But let there be president of the US, Louis Heren, then among its unchecked, unlimited, and no change by usurpation; for though this Washington correspondent for the Times unelected “guardians” of the American in one instance may be the instrument of of London, wrote a perspicacious, if people. To use Mr. Heren’s analogy, what good; it is the customary weapon by which wrong-headed, book, which described we have witnessed in the Kennedy, the governments are destroyed. The precedent the dominance of presidential power in Johnson, and the Nixon administrations is must always greatly overbalance in American government in this fashion: a return to that period of English history permanent evil any partial or transient when the power was not wielded solely by benefit which the use can at any time yield. the king, but by the king and his council, to the period that led up to the American We are governed today by a far different Revolution. constitution than that which Washington A startlingly perceptive and insightful bequeathed us. And the most basic work, Harvard Professor Bernard changes have not been brought about by Bailyn’s The Ideological Origins of the means of constitutional amendment, as American Revolution, published in 1967, Washington would have had it. We have demonstrates that the intellectual case for seen the concentration of power in the the American Revolution was based not presidency that has been achieved by the so much on those simplifications about usurpation of which Washington warned George III that are taught in our history us, aided largely by the abdication of courses, as on the notion that the English responsibility by the Congress. We are, constitutional system on which all men’s indeed, threatened by that despotism liberties depended had been perverted by which he decried, whether it may be called The rst step the men around the Crown in conjunction “benevolent” or not. with the king rather than by the king Watergate, however, has brought the back toward our alone. Read Bailyn’s words, and his use specter of totalitarianism to the attention of the words of those who lived in the of the American public. Now, as hardly consitutionally era that gave birth to our nation, and ask ever before, we are cognizant of the crisis established yourselves whether the explanation does that we face. For the first time in many not fit our day equally well: years, Congress is seeking to assert itself. democratic The question is whether or not it is too late The most common explanation, however, to restore the constitutional balance that principles an explanation that rose from the deepest our Founding Fathers created. is to remove sources of British political thought, located “the spring and cause of all the The trend toward concentration the powers distresses and complaints of the people Heretofore, crisis has been the in England or in America” in “a kind of handmaiden of presidential power. accumulated fourth power that the constitution knows Whether the crisis was economic, as was nothing of, or has not provided against.” the case when Franklin Delano Roosevelt in the so-called This “overruling arbitrary power, which first came to power, or a military crisis of Executive Oce absolutely controls the King, Lords, and the kind that has plagued every generation Commons,” was composed, it was said of of Americans, at least since World War of the President. the “ministers and favorites” of the King,

72 Chicago Booth Review Winter 2017/18 who, in defiance of God and man alike, plagued us. The distinguished French “exerted their usurped authority infinitely We live in an age historian François Guizot supplied the too far,” and “throwing off the balance of when it is no longer introduction to Jared Sparks’s biography of the constitution, make their despotic will” Washington. In 1837, Guizot wrote: the authority of the nation. the love of money For their power and interest is so The disposition of the most eminent men, great that they can and do procure that is the root of all and of the best among the most eminent, whatever laws they please, having (by to keep aloof from public affairs, in a free power, interest, and the application of evil; for our time, it is democratic society, is a serious fact. . . . It the people’s money to placemen and the love of power that would seem as if, in this form of society, pensioners) the whole legislative authority the tasks of government were too severe for at their command . . . the rights of the is the root of all evil. men who are capable of comprehending people are ruined and destroyed by its extent, and desirous of discharging the ministerial tyrannical authority and trust in a proper manner. thereby . . . become a kind of slaves to the ministers of state. Today we are suffering not only This “junto of courtiers and state- from a corruption of the constitution jobbers,” these “court-locusts,” whispering through perversion of the institutions in the royal ear, “instill in the King’s mind of government, but a corruption of the a divine right of authority to command his constitution because the men we have subjects” at the same time as they advance established democratic principles is to chosen for high office are unworthy. A US their “detestable scheme” by misinforming remove the powers accumulated in the president who tells us that he is “not a and misleading the people. so-called Executive Office of the President, crook” thereby affords little reassurance to dissipate the Office of Management and of his qualifications for office, even if we Bailyn also wrote, “For the primary Budget, the National Security Council, the could still credit him with a capacity for goal of the American Revolution was . . . the Council of Economic Advisers, the czar the whole truth. It is not enough that the preservation of political liberty threatened of this and the emperor of that. Put these US president is “not a crook.” There is by the apparent corruption of the functions back in offices that are subject more to honor and duty than not stealing constitution.” The American Revolution to congressional control and public from the public fisc. The reassurance we was a political revolution, not a social scrutiny, or in administrative agencies need—and have not received, because or economic revolution. It was fought that can be made totally free of Executive deeds and not words are the only cogent to restore the constitutional balance Office corruption. evidence here—is that the authority of the that Englishmen and Americans thought Watergate, however, is the consequence US government is not expended merely to essential to the liberties they claimed. In not of one but of two kinds of corruption. effectuate the personal whims or wishes the two centuries that have elapsed, the The first is that which I have described of those in high authority nor to benefit “corruption of the constitution,” which as the “corruption of the constitution.” their personal friends and do harm to their they deplored, has once again occurred. The second kind of corruption revealed personal enemies. We live in an age when And, if our liberties are to be preserved, by Watergate is the corruption of the it is no longer the love of money that is the we should be looking to the means to people and particularly of individual root of all evil; for our time, it is the love of restore the constitutional balance among officeholders. We have forgotten what power that is the root of all evil. the three branches of government. a little-known Supreme Court justice, A system of presidential selection— The first step toward the restoration Noah Haynes Swayne, in a lesser-known not, incidentally, the one created by the of our constitutional democracy would Supreme Court case (Trust v. Child), once constitution—that leaves the voters a be the abolition of the “fourth branch wrote: “The theory of our government choice between the devil and the deep of government”—to quote again from is, that all public stations are trusts, and blue sea, as it did in the 1972 election and Bailyn’s sources—“a kind of fourth power that those clothed with them are to be in some earlier elections, helped bring us that the constitution knows nothing of, or animated in the discharge of their duties to this grievous point in our history. But has not provided against.” solely by consideration of right, justice and that is another tale that requires another the public good.” time for the telling, however short of time The power around the president The fact is, of course, that no we may be. I don’t know yet when the euphemism institutions, however perfect, can function The crisis called Watergate has provided “the White House” first came into use as without the appropriate human beings us pain and suffering, outrage and disgust, a description of something other than the to run them. The Founders had in mind fear and trembling. It has also afforded presidential mansion at 1600 Pennsylvania not only a concept of the presidency us an opportunity not likely to come Avenue. But it was exactly when “the White but the kind of man they wanted when again, to reexamine the “corruption of the House” became what it now is, a fourth they prepared Article II. Despite their constitution” from which we have been branch of American government, that great respect for Washington, they suffering these many years and to try to we were committed to take the road that limited the executive power as no effect a remedy before it is too late. led to Watergate. And this long journey national government had ever before probably began with the single step of the limited executive power. The need for a Philip B. Kurland was William R. Kenan Jr. statutory authorization of Roosevelt in the Washington was, nevertheless, pervasively Distinguished Service Professor Emeritus Reorganization Act of 1939. Therefore, the felt. The problem of finding the right men in the College and the Law School at the first step back toward our constitutionally for the right governmental posts has long University of Chicago. He died in 1996.

Winter 2017/18 Chicago Booth Review 73 THEIGMPANEL

WHAT CONTRIBUTED MOST TO THE FINANCIAL CRISIS? Nearly a decade has passed since a number of calamitous events shook the global financial system and sparked what became a years-long crisis. To help explain the conditions that put the economy in dire straits, Chicago Booth’s Initiative on Global Markets sent its US and European experts panels a list of 12 factors that may have contributed to the meltdown, and asked them to assign a weight of 0–5 for each depending on its “importance in contributing to the 2008 global financial crisis.” As the results demonstrate, many factors received a considerable degree of blame, underscoring the complexity of the crisis— and, perhaps, the difficulty of preventing the next one.

About the IGM Economic Experts Panels See more online To assess the extent to which economists agree or disagree on major public policy issues, All responses to this poll can be seen Booth’s Initiative on Global Markets has assembled and regularly polls two diverse panels at igmchicago.org/igm-economic- of expert economists, all among the leading researchers in their fields in the United States experts-panel. and Europe. The panels include Nobel laureates and John Bates Clark medalists, among others. Questions are emailed individually to the panel members, who may consult whatever resources they like before answering. Members of the public are free to suggest questions.

74 Chicago Booth Review Winter 2017/18 PHOTO ILLUSTRATION BY GLEN GYSSLER José Scheinkman, Princeton European panel Average rating, 0.00 (0.00) (Unweighted US panel weighted by average) “Inflated housing prices would experts’ conﬁdence have collapsed, but with much All respondents less severe global consequences if financial institutions had not chosen to hold as much housing Factors Importance ratings “No opinion” responses risk (due to greed or stupidity) or Flawed ﬁnancial 4.3 (4.36) 4.37 1 if regulators and rating agents sector regulation (4.34) had done their jobs.” and supervision 4.45 (4.32) 0

Underestimated 4.11 (4.19) 4.04 1 risks (ﬁnancial Robert Hall, Stanford (4.08) engineering) 3.95 (3.97) 1 “The government’s policies of Mortgages: bailing out financial institutions 3.72 (3.76) 3.76 0 Fraud and (3.74) created a fragile financial bad incentives 3.81 (3.73) 0 system. Financial collapse resulted in a major loss of Housing-price 3.66 (3.59) 3.69 0 confidence.” beliefs 3.73 (3.65) (3.62) 0

Hélène Rey, Ratings-agency 3.58 (3.69) 3.58 2 failures (3.67) London Business School 3.58 (3.66) 2

“Many factors contributed to the Funding runs 3.47 (3.78) 3.31 5 (short-term 2008 global financial crisis. But (3.69) liabilities) 3.12 (3.6) 7 at the heart of the mechanism was a dysfunctional financial Household 2.95 (3.06) 3.03 2 sector with misallocation debt levels 3.15 (3.11) (3.08) 1 of capital, bad incentives, insufficient supervision, and Too-big-to-fail 2.75 (2.84) 2.66 0 some fraudulent behavior.” beliefs 2.54 (2.67) (2.75) 1

Government 2.09 (2.21) 2.3 4 subsidies: Mortgages, (2.33) home owning 2.58 (2.43) 0

Savings 2.28 (2.36) 2 4 and investment (2.23) imbalances 1.63 (2.07) 8

Loose 1.96 (2.06) 1.96 2 monetary policy 1.96 (1.97) (2.01) 1

Fair-value 1.43 (1.74) 1.36 9 accounting 1.27 (1.82) (1.78) 9

0 1 2 3 4 5

No importance Highest importance

PHOTO ILLUSTRATION BY GLEN GYSSLER Winter 2017/18 Chicago Booth Review 75 THEBIGQUESTION

How do the early-childhood years affect your ability to climb HOW CAN WE the socioeconomic ladder?

Kalil: Children need both cognitive IMPROVE SOCIAL and what we call noncognitive skills to succeed in life, to perform well in school, to perform well in the labor MOBILITY? market, to get along with other people. These skills are crucial both for improving social mobility and Chicago Booth’s Amir Suﬁ and University of for mitigating inequality. Chicago’s Ufuk Akcigit and Ariel Kalil discuss how Although there is opportunity early-childhood development, innovation, and for skill development throughout the life course, the early years inequality affect social mobility. are critically important. Early childhood is a period of rapid brain development, when the path to skill development is laid down. So it’s a formative period, and parents and the home environment play an important role in helping children acquire those key skills. Ufuk Akcigit Children’s ability to think and to Assistant Professor of solve problems, as well as their Economics, University preliteracy and premath skills, and of Chicago their understanding of the world and how to get along with others all have to do with the quantity and quality of time that caregivers spend with children on particular activities, such as reading books, playing puzzles, simply talking to children, helping them solve problems, etc. That kind of interaction typically Ariel Kalil comes from parents, but it could Professor, University of come from anyone. It need not be Chicago Harris School only the mother; it need not be of Public Policy only the father. There is a range of important caregivers, typically, in a child’s life.

How does innovation relate to social mobility?

Akcigit: Along with colleagues, I’m studying the importance of innovation for the macroeconomy. Amir Suﬁ And our overarching research Bruce Lindsay Professor question is: Why do we care about of Economics and Public innovation, from a macroeconomics Policy, Chicago Booth standpoint? And we ﬁ nd three

answers to this question. KENZIE JOHN BY ILLUSTRATIONS

76 Chicago Booth Review Winter 2017/18 First, innovation is the sole “If we have a lot of Who are the innovators? What do driver of long-term economic we know about them? growth. In the long run, social mobility, that economies are growing only due Akcigit: What we find across to technological progress and allows new entrants numerous studies is that, first, innovation. The second answer we education is an extremely important find is that when we look at the to catch up with ingredient for becoming an relationship between well-being, incumbents.” inventor. The second important or happiness, and innovation, we ingredient is having rich parents— — UFUK AKCIGIT see a strong association between that helps a lot. But this strong innovation at the regional level association between having rich and the happiness of the region’s parents and becoming an inventor individuals. And the third aspect disappears completely once you of it is that innovation is leading control for a child’s education. to growth in average incomes, but Parental income matters because how does that growth evolve across [rich parents] are able to afford a generations and how does it get better education for their children. spread? And what we see in the So an immediate conclusion data, starkly, is that innovation, suggests the importance of or the turnover in the economy, education for innovation, which is strongly associated with social later on also leads to social mobility. mobility. In regions where there’s a lot of turnover, there’s also Kalil: A child’s skills are jointly high social mobility. And this is produced, however. We can’t particularly true if innovations assume that a lack of opportunity are coming from new entrants, for learning in the home young entrepreneurs. environment can be made up for by And one more interesting result schooling. For one thing, children we find is that this strong association who arrive at school with fewer between entrant innovation and skills will get less out of the learning social mobility gets much weaker environment that is provided to in regions where incumbents are them there. Secondly, the sheer spending more money on lobbying amount of time that children spend activities. Because, as you can in home environments, or in the imagine, innovation is a process of company of caregivers, trumps the creative destruction, where new time they spend in school. There entrants are coming and replacing certainly can be cases where there’s the incumbents. And this, of course, a fabulous school environment; creates the chance for the child of but in general, we should not think an assembly-line worker to become that better education is a solution the business owner. If incumbents for improving social mobility on its are slowing down this process, that own. We can certainly think about is going to have a negative impact on a joint effort. But it’s really not one social mobility. versus the other; it’s those two In a parallel study, we try to environments combined. also understand how politically connected firms affect innovation. How does inequality relate to Where incumbents are politically social mobility? connected, where they are hiring moonlighting politicians, we observe Sufi: Social mobility is a dynamic a much lower entry rate into those concept referring to how people industries. And, of course, that is move throughout the income going to have negative consequences or wealth distribution, whereas on social mobility as well. inequality is more a static statement

Winter 2017/18 Chicago Booth Review 77 THEBIGQUESTION about, currently, how does the top prominent example is the ease with 10 percent of the wealth distribution “Debt, as a nancial which people can borrow against compare to the bottom 10 percent? contract, really is the value of their homes. Thirty They’re related in that we might think or 40 years ago, it was almost high inequality may exacerbate the a pretty terrible impossible to take out what’s called decline in social mobility, but the a home-equity loan, or cash-out evidence is a bit mixed on that. contract if you’re refinancing, where you literally a middle- or go to the bank and say, “I want to Akcigit: If we have a lot of social take out more money because my mobility, that allows new entrants to low-income home’s value has gone up.” Now, catch up with incumbents. If there’s a and especially in 2004–06, it was lot of turnover in the economy, that’s person, because it incredibly easy to do that. going to have a negative impact on Subprime auto loans are inequality because it’s going to shrink essentially forces another innovation. People the income distribution. On the other all the risk on you.” far down in the credit-score hand, as I highlighted earlier, there is distribution can now borrow a connection between being from a — AMIR SUFI almost the entire value of the car rich family and becoming an inventor, when they buy a car. So that’s one and that has an impact on social way in which inequality is affecting mobility. It looks like we are not the financial system and thereby giving an equal chance to everybody. affecting borrowing patterns.

Suﬁ: We’ve seen a sharp rise in How does that compare to the measures of inequality over the last long-term view of innovation 40 years. A lot of people have focused and social mobility? on a “keeping up with the Joneses” story, because simultaneous with that Akcigit: We digitized all the patent rise in wealth inequality, we’ve seen records since 1836 in order to a sharp rise in household-debt levels, uncover the inventors in each of measured just about any way you those patent ﬁles. Then we merged want to measure them. And a lot of them with the decennial US census people say, “Oh, that’s because lower- records between 1880 and 1940, income households, people in the which made it possible to see median of the income distribution, all these historical inventors of they need to borrow more to get this golden age to whom we owe an education, to buy a car, to buy a bicycles, refrigerators, safety pins, home, in order to catch up, in some you name it. sense, with more-wealthy people.” And it’s an interesting question: The narrative that we actually Who are they? There are some believe is more relevant is more facts that are similar to today: for of a push rather than a pull factor instance, back then, innovation coming from the financial sector. was strongly associated with social Because people who are extremely mobility as well. But historically, wealthy consume, or spend, so little innovation was a little bit more of of their wealth, as you get a rise in a democratic activity in the sense wealth inequality, more and more that most of the inventions in the money comes into the financial beginning of the century were system. That system, of course, is done in garages. When you look charged with going out and trying to at the patent records, about 70 find good investment opportunities, percent of patents were assigned to good ways of making use of those individuals. Whereas today, more funds. In our view, perhaps there than 90–95 percent are assigned just aren’t enough good investment to nonindividuals, to corporations opportunities in, say, the private or universities. sector. So a lot of that savings gets transformed into borrowing by Kalil: We’ve taken a similar lower-income people: subprime historical perspective to look at mortgages, subprime auto loans, change in inequality in learning more education loans. opportunities between rich and The ease with which households poor kids, for example. One thing below the 70th percentile of the we’ve noticed is that, over time, wealth distribution can get credit has there has been an increase for increased over the last 30 years. One rich and poor families alike in the

78 Chicago Booth Review Winter 2017/18 amount of time that they spend with house and a $100,000 mortgage, kids. And to such a great extent that, and house prices drop by, let’s say, at present, the home environments 50 percent. Well, then, you end up of low-income kids look a lot like the eating the loss, not the bank. Your home environments of rich kids 30 mortgage is still going to be worth years ago. So you could say, well, $100,000. The way debt contracts that’s a good thing. But just as low- work is that they concentrate those income caregivers have increased losses on the debtors, who tend to their time, so too have high-income be lower-income people. One idea caregivers. And so, in fact, the gap is to try to put more equity-like has shrunk very little, because high- ﬁnancing into the market so that risk income parents are doing orders of is shared more equally between magnitude more than they did 30 the rich and the middle- and low- years ago. income households.

What are some policies or Kalil: A puzzle that we have to solutions that can decrease solve is: How much cognitive and inequality or foster innovation emotional stimulation is necessary and social mobility? for healthy childhood development? Is there some absolute level that Akcigit: One policy conclusion will indicate, “This child is ready to coming from our analysis is that succeed”? Even college-educated access to education is a very, very and/or rich parents are not spending important tool. I also mentioned five hours a day reading or playing that innovation has an unusual puzzles with their kids, but what relationship with happiness, and the they’re doing is spending, let’s say, reason is that, through innovation, 20–30 minutes a day on a particular you’re also replacing some kind of learning activity that’s companies, which means there can relevant for children’s development, be many workers who are going and they’re doing it every day. What on unemployment. And especially we see in lower-income households these days, when technology’s is that these activities happen much evolving at a fast pace, we observe less frequently. When low-income that it’s typically the older workers parents do spend time with their who are not able to find a new job kids, the actual number of minutes quickly. We see that the relationship does not differ that much from their between innovation and happiness high-income peers; it’s just that it gets much tighter in regions where happens, as I said, less frequently. unemployment benefits are higher. There are many different demands If we take into account not only on low-income parents, many fewer the winners but also the losers in resources, much less social support, innovation, we can create bigger many fewer peers around them gains from this entire process. who are reinforcing these kinds This doesn’t mean we necessarily of activities. have to increase unemployment Our research suggests that benefits, but introducing some they aspire to interact with their training programs for the people children, but somehow, for many who are losing their jobs could be people, life gets in the way of the an important policy tool. things we want to do. My colleagues Another important policy and I have thought about how to conclusion coming from these design an intervention that helps studies is that we need to adapt parents set goals, reminds them procompetitive policies, which will “There are many of the goals they’ve set, and gives make it easier for new entrants to them some sort of social reward come in and create this turnover that dierent demands or feel-good feedback for meeting we want. their goals. We send them text on low-income messages to congratulate them on Sufi: Debt, as a financial contract, parents, many fewer meeting their goals. It’s really as really is a pretty terrible contract simple as that. We do these simple, if you’re a middle- or low-income resources, much less light-touch, low-cost kinds of person, because it essentially forces interactions, and we find dramatic all the risk on you. The example I social support.” increases in the behavior of always give is: you have a $200,000 — ARIEL KALIL interest.

Winter 2017/18 Chicago Booth Review 79 How to maximize shareholder welfare

company may want to focus solely on making money for shareholders, but these investors are likely to have social goals as well, such as reducing pollution and promoting fair practices. The problem is that shareholders can’t always oﬀset a company’s “dirty” A policies; nor can they always rely on government to curb such activities. Under these conditions, a company that’s maximizing shareholder value may not be maximizing its shareholders’ welfare, according to Harvard’s Oliver Hart and Chicago Booth’s Luigi Zingales. As a way to maximize welfare, the researchers suggest letting shareholders vote on company policy. Voting would ensure “clean” policies prevail, but only if enough shareholders care about them. To read more about how this concept could change the way corporations are run, turn to page 64 of this issue.

802 Chicago Chicago Booth Booth Review Review Season SeasonWinter 2016 2017/182016 ILLUSTRATIONILLUSTRATION BYBY NAME PETER TEEKAY ARKLE December to March

Executive MBA Information Session: Singapore

DECEMBER ¯ JANUARY © JANUARY ©© Executive MBA Information Session and Polsky Collaboratorium, Chicago. Economic Outlook, New York. Master Class, Singapore. Chicago Booth’s Students, researchers, technologists, “From Wall Street to Main Street: A Michael Gibbs will conduct a master class and faculty can network, pitch Decade after the Global Financial for alumni and prospective students. Other cutting-edge research and Crisis”—Chicago Booth’s Erik Hurst information sessions will be held this winter technologies, and explore and Randall S. Kroszner discuss in Dubai, United Arab Emirates, and Munich. commercialization opportunities. prospects for the global economy. ChicagoBooth.edu/alumni/events polsky.uchicago.edu/events ChicagoBooth.edu/eo

DECEMBER JANUARY

JANUARY © FEBRUARY FEBRUARY ¬ MARCH ©ª–¬ Economic Outlook, Chicago. Meet the Dean, Hong Kong. th Annual Private Equity The Advanced Strategy “From Wall Street to Main Street: Get to know new Chicago Conference, Chicago. Hosted by Program: Building and A Decade after the Global Booth Dean Madhav Rajan Chicago Booth’s Private Equity Implementing Growth Financial Crisis”—Chicago and hear his thoughts Group and the Polsky Center for Strategies, Chicago. Booth’s Austan D. Goolsbee, about the future of the Entrepreneurship and Innovation, Develop a strong Randall S. Kroszner, and school while networking the conference features a lineup of strategic intuition at Raghuram G. Rajan discuss with alumni, students, and distinguished industry speakers and the senior executive prospects for the global economy. faculty. ChicagoBooth.edu/ panelists. student.ChicagoBooth. level. ChicagoBooth. ChicagoBooth.edu/eo alumni/events edu/group/pe/conference.htm edu/asp

FEBRUARY MARCH

Since 1898, the University of Chicago Booth School of Business Visit ChicagoBooth.edu/programs for more information about has produced ideas and leaders that shape the world of business. our Full-Time MBA, Evening MBA, Weekend MBA, and Executive Our rigorous, discipline-based approach to business education MBA programs, our PhD degree, and our Executive Education transforms our students into conﬁdent, eﬀective, respected busi- courses. Chicago Booth has campuses in Chicago, London, and

ISTOCK ness leaders prepared to face the toughest challenges. Hong Kong, as well as a center in Singapore.