Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Jim, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This talk is also a live recording of the Capitalism and Freedom in the 21st century podcast of the Hoover Institution where we talk about economics, markets and public policy. where I’m Jon Hartley, your host. We’re here at the 2026 Miami Economic Forum on February 27, 2026. Today my guest is Jim Esposito who is the President of Citadel Securities where he’s responsible for driving the long-term growth of the firm’s global client and partner relationships. He previously worked at Goldman Sachs for 29 years where he was co-head of global banking and the global banking and markets division. He was also the co-head of the investment banking and global markets division separately before they were merged into both the investment banking and broker dealer divisions. He also served on the management committee and co-chaired the partnership committee at Goldman. He also earned his BA at Brown where he’s a trustee and he also holds an MBA from the Tuck School of Dartmouth University where he’s also on the board of overseers. Welcome Jim. Really thrilled to have you here.

Jim Esposito: Thanks Jon for having me.

Jon Hartley We’re sitting here in Miami. Some call it Wall Street South. I know our audience is very familiar with Ken Griffin, Citadel’s founder. We had a chance to speak with Ken a few years ago here. but I suspect that folks may not be as familiar with Citadel Securities. I’m curious, what is Citadel Securities role in financial markets?

Jim Esposito: I think that’s a great place to start, Jon. I do think there’s sometimes a lack of understanding, you know, when people hear Citadel, the overall brand, and I’d start from this place of reminding the group that Ken Griffin didn’t just found one incredibly successful company. He actually founded two. I find people are very familiar with Citadel, the asset manager. That’s the hedge fund side. The hedge fund is generally considered to be the most successful hedge fund ever launched and that’s based on the return performance of that fund. I have nothing to do with Citadel the hedge fund. So I am president of Citadel Securities. We like to think of ourselves as a next generation technology driven market maker. We make markets to clients across global equities and fixed income.

Many of you would see the big trading floors in New York that a bank like JP Morgan, Morgan Stanley, Goldman Sachs has. We’re the equivalent of those big banks in global equities where we are particularly big. I would suggest we’re actually bigger than those same banks that I just named. We trade more equity flow than anybody else around the globe. And when I sort of you know go through what we actually do in equities, I think this will inform the group’s thinking for the talk we’re about to have. We execute equity volumes through three distinct channels. The first is our on exchange market-making business. To put that business in context, on any given day, we’re about one third of the volume that gets executed on the New York Stock Exchange. So, very big on exchange presence. The second place we have a large client presence is in the retail market around the globe, but particularly here in the US. We account for about 35 to 40% of all retail flows across single shares and equity options. So if any of you have an account at Robin Hood or Charles Schwab or many other retail brokers, we’re basically the execution engine for those platforms dominant retail presence. And then the third place we meet clients is directly with the biggest institutions in the world. These would be names you recognize from BlackRock to Fidelity, PIMCO, all of the large sovereign wealth funds, insurance companies, pension funds, and hedge funds. So, you know, we’re the 800 pound gorilla in markets and we’ll talk a little bit about how we accomplish all that, I’m sure.

Jon Hartley: So, so I’m curious like what makes Citadel Securities different or what sets it apart from say like JP Morgan or Goldman Sachs? I know JP Morgan, Goldman Sachs are bank holding companies. How is Citadel securities different in in this market making business?

Jim Esposito: A couple ways. We are solely I should say maniacally focused on market making. We don’t have an asset and wealth management arm. As I suggested, Ken has the separate hedge fund. We don’t have an investment bank attached to us. We don’t underwrite IPOs or debt issuances solely focused on market making. But importantly, I would say versus the traditional big banks, we have two what I like to think are competitive advantages. The first is we have achieved an operational scale and efficiency by leveraging technology that I think is really the envy of not just the banks but maybe any other company on the planet. And I say that because we account for about just shy of 25% of daily US equity flows and we only have 1,900 professionals in all of Citadel securities. If you were to look at the headcount those big banks have against the same opportunity set, they have 10,000, 15,000, 20,000 employees doing middle and back office settlements. The banks talk about now leveraging tech technology generally incorporating AI to become more efficient. I would suggest we’ve already accomplished that. And so we were a company built and founded on the principles that technology is the best way forward. We’ve been at this now for well over 20 years and we’ve extracted that technology dividend in the way that maybe some of your own companies are only now starting to think about. The second competitive advantage that we enjoy, we’re very good at monetizing very basic trading flows and the reason for that is we really sit at the intersection of where finance meets quantitative research and technology. And so when I look at the composition of our 900 professionals, about 300 of our employees hold a PhD and these PhDs are kids that come to us from literally the best schools around the globe. And these are kids that got a PhD in math, statistics, computer science, and physics. We attract the best and I mean the very best in those STEM educational fields. Our CEO Peng Zhao was born in China came to the US to get a PhD in statistics at Cal Berkeley. Peng is very much a talent magnet attracting you know some of the brightest PhD minds in our country. By the way, many of them actually sit here in Miami. We have a big quantitative researching capability here in Miami. It’s that operational scale and efficiency combined with this quantitative researching capability that I think sets us apart.

Jon Hartley: Well, terrific. Well, I want to get back to you and get into your origin story a little bit. So, where did you grow up and how did you get interested in finance to begin with?

Jim Esposito: You’re going to make me blush or cringe that I have to talk about myself. I’d rather talk about Citadel Securities, but I’ll give you the high level basics. And look, you you ran through my background, my educational background and my previous professional background. but I just say a couple things maybe just to kind of, you know, understand what makes me tick. I did grow up in the state of New Jersey. I was a product of the public education system. I have two older brothers. And the reason I mention that is when I think about my younger formative years, I grew up in a household particularly with my two older brothers where we competed in anything and everything. I grew up with a love for competition. A lot of that manifested itself in sports. I don’t know if any of you are familiar with the sport of wrestling. I was a decent student in high school, but I was an even better high school wrestler. Wrestling is the ultimate competitive sport. It’s a one-on-one sport. You learn to compete. You definitely learn to lose, pick yourself up, and go again and again and again. There’s a really grinding element to the sport of wrestling that I think rhymes with the success that I’ve had in my career. I think it’s a really important part of who I am as a professional. Even though wrestling was a long long time ago, I actually got recruited to wrestle at Brown University where I majored in political science and economics. So Jon, I know you’re proud of me. That was an important time in my life. When I fast forward that to thinking about Citadel, and here I will be specific to Ken Griffin, I’ve never met anyone, and I literally mean anyone who has a love for competition quite like Ken. Ken is the ultimate I mean the ultimate competitor. I think it’s easy to say Ken loves to win and he does win, but it’s that love for competition, this notion that we come in every day with a mindset and a mentality that we want to get a little bit better, a little bit better every day and then compound that success over a longer period of time. We play to win at Citadel Securities. we talk about that a lot. When we enter a new business line, a new product, we’ll only do it if we think we can win. Winning for us it means being the best, being number one in that given product or that given area. Ken sets that winning mentality, that love of competition through the entirety of Citadel. It might not resonate with everyone. I think for the people that stay that is a common thread. We share this spirit of competition and winning set by Ken. And so my early background aligns quite well I think with the culture at Citadel.

Jon Hartley: So fast forward here I’m just curious about for about you know 30 years in senior leadership roles at Goldman Sachs and New York and London. I mean, why did you leave the world of large New York banks for a market making firm and now a life here in Miami?

Jim Esposito: Yeah, I think that’s actually an interesting question. So, I left Goldman Sachs after just shy of a 30-year career. Goldman Sachs is a preeminent, maybe the preeminent global investment bank. I had a an amazing career there. I loved every single minute of it and I got to have a really diverse career there. So at some point in my career, I co-ran the global capital markets business which warehoused all the new issuance for equities and debt securities. I co-ran global investment banking and then I co-ran the global markets business where equity and fixed income trading resided. So, I got to do pretty much everything on offer and I climbed that mountain and I thought it was an amazing time. And then I got to a place in my career where I realized if I were going to stick around for the next 5 years, it was going to be a little bit of, you know, shampoo, rinse, repeat. I wasn’t that young, but I was young enough to know I could go out and do something different. I think I did something hard. Um, I think my spouse thought I was crazy. But really at the, you know, kind of the top of my career there, I decided it wasn’t obvious I had one more rung to climb there. And while I didn’t know exactly what I wanted to do, I think I had a checklist in my mind of things that I wanted to try. Okay. And in that checklist would have been things like I wanted to do something more entrepreneurial. I wanted to join a faster growing company on the margin. I wanted to be a private company, not a public company because I thought that could be an interesting challenge. And then I was hoping to kind of ride some of the trends of the things that I talked about earlier, technology, AI, and to see if I could find a place where I could lever the skills that I had built up over my 30-year career, but maybe deploy them into the faster growing side of the economy. So, I had that in my head and then I decided I was going to leave. It was emotional for me and for many at the firm. And so, that’s what I did. And I’ll tell one quick story because I think people always do enjoy Ken’s stories. So the day my announcement came out from Goldman Sachs that I was leaving, I had decided I was just going to sit in my I was based in London at the time. Was going to sit in my office and just enjoy that moment. 30 years of hard work of real, you know, sweat equity that I put into that that place in that job. So my announcement comes out. But it was a surprise to many. It crosses the tape. I’m in my office. My phone’s blowing up. My email’s blowing up. People are trying to come in. And I was just sitting there kind of taking in the moment. I shut my ringer off on my mobile phone. I wasn’t going to answer any calls. But at some point early on, I looked down at my phone and I see this name scrolling across. Ken Griffin. Ken Griffin. Ken Griffin. I was like, “Well, there’s going to be one carve out for my rule. Well, I’m not going to answer my phone. It it’s going to be for this. I knew Ken a little bit, but we didn’t have a deep relationship. So, I picked up the phone and Ken was incredibly upbeat and energetic. He said he had seen my announcement and it was amazing timing. And I said, “Why is it amazing timing?” He said, “I’ve been thinking about you, Jim. I think I have the perfect next opportunity for you.” I was respectful. I said, “Ken, that’s amazing that you’re thinking about me. That’s exciting, but I need a little time. I promised my wife and kids, you know, I was going to detox, certainly take more than a couple of months off, wash the Goldman Sachs out from under my fingernails.” And I said to Ken, “You’ll be the first person I come to see. So, just, you know, give me some time, couple months. I’ll leave London. I’ll come through Miami and I’ll come see you but you’ll be the first. Ken said, ‘Yeah, that doesn’t work for me. [laughter] said, ‘What do you mean?’ He said, ‘I told you I have something for you that’s incredibly exciting. I have an amazing opportunity for you. I tried one more time. I said, “No, no, Ken. I understand. I’ll get there.” He literally said, “Jim, I’m free next Tuesday afternoon in Miami. My assistant’s going to call you to follow up on your flight details. I’ll see you next Tuesday.” Click. I was an hour early for that meeting with Ken [laughter] and that started an amazing discussion and ultimately an amazing journey that took me from London to here in Miami where I’ve been you know for just shy of two years about 18 months now at Citadel Securities and I’m not only glad I picked up that phone call I’m super happy that Ken is Ken and doesn’t take no for an answer.

Jon Hartley: That’s amazing that’s a great story. you got to jump on opportunity while it’s while it’s there. Okay so you lived in New York, lived in London, Miami Finance and all these places. How would you contrast these experiences exactly?

Jim Esposito: So look, I think I had a great privilege to live and work in three of the most dynamic and important financial centers in the world. First New York, then London for almost 15 years, and now in Miami. I think all are amazing for different reasons, but let’s focus on Miami as a financial center and as a financial hub. It’s early for me here. but in some ways, Miami rhymes with some of my experiences in London, and at first blush, of course, that comment doesn’t make any sense. but what London did well as a financial center, it really built interesting ties and bridges to the rest of the world. Now, London did that well because the geography set up well, you know, in terms of the time zone. It linked back to the rest of the world, maybe better than New York. Perhaps New York benefits. It’s so big and so important. It’s almost like its own self-contained ecosystem. What I’m seeing and feeling in Miami, it’s obviously particularly true at this time of year. Miami as a destination is an amazing place. And so whether it’s FII, you know, Saudi Arabian delegation coming here, the natural ties back to everything and everywhere in Latin America, Miami as a destination is incredible. This time of year, every major bank hosts a financial services conference. Every hedge fund is coming through. And so sometimes people say, “Well, is Miami going to be big enough? Do you have a natural ecosystem? I have no reason to be in New York at this time of year. Everybody comes through and I see everybody here. So, my client game at this time of year is actually better than it would be in New York. And so, I think it’s important for, you know, local officials, policy makers to continue to build those bridges back to the rest of the world. I think that’s a way to accelerate Miami’s growth as a financial hub and a financial center. I think it’s doing it well. I’d be particularly focused on now, can we build, you know, deeper bridges to Asia? I think there’s opportunities there. So, that’s very much on my mind. Look, the obvious things that I’ I’d say about Miami, and perhaps we can talk about this in some of our other experience that you mentioned to me in the green room. You know, Miami has Florida has such a positive can do attitude. The way that the local community, the way that, you know, public sector officials have embraced us as a company is like something we hadn’t seen before. And so this public and private sector partnership and cooperation and collaboration is noteworthy here. It means a lot to us as an institution. There’s a can do positive attitude of solving problems together and wanting to really lift the entire society here to make the education programs better and better and better. And so we’re a part of this vibrant community. It’s working for our leadership group. It’s working for our junior people. And so Miami is a very, very special place. And I’m glad that my career, you know, kind of followed that journey.

Jon Hartley: So maybe Miami can call itself Wall Street South soon with Citadel Securities. We’ve got you know, Carl Icahn, a lot of hedge funds that are here now. Obviously, you know, Founders Fund, a lot of VC firms that are here. It’s growing. I want to talk about I guess one famous story related to South Florida and Citadel Securities and this was about how Citadel Securities famously built a trading floor in Palm Beach in about a week at the Palm Beach Four Seasons. And so, you know, by the numbers that you were giving earlier, I think you you’re handling you built basically um a setup in I presume some sort of a dining room or a conference hall that was handling like 20-25% of the US equity trading flow or something like that in a week. I mean, what prompted that and how did it translate into you sort of ultimately moving your headquarters to here in Miami, South Florida from Chicago?

Jim Esposito: Yeah, this might be the most Citadel Securities-esque story I could tell. And there’s a lot in it in terms of what makes us tick and for our company, it’s actually is our founding roots and our origin story here in the state of Florida. So, obviously, COVID was an incredibly difficult period. The vast majority of us in the room and pretty much every other company around the globe opted for a work from home strategy and that had varying degrees of success, but that was pretty much the only choice on the menu, unless of course you’re Ken Griffin. So Ken for a variety of reasons, but I would just highlight two. One is we do play a critical role in the capital markets. I reference the amount of securities we trade every day. We were really nervous and worried about the safety and security and the functioning of the capital markets. We play a vital role and we take that responsibility incredibly seriously. The reliability and the durability of our technology stack to service clients. We think about that responsibility every single day. We account for just shy of 25% of equity volumes. But what Ken and Peng tasked the leadership group at Citadel Securities with was not just to be able to accommodate our normal flows. The homework assignment was what if nobody else can get up and running. We want Citadel Securities to build an ecosystem and a trading floor in a single hub that can accommodate 100% of equity trading volumes. Let’s assume no one else gets up and running. How are we going to do that? Wow. Working from home with that as your homework assignment didn’t seem like that was going to be a winning hand. And so through a lot of determination and a lot of local support, we rented the Four Seasons Hotel in Palm Beach and basically took over the entirety of that hotel. Not only did we live up to that challenge, we accomplished turning ourselves on and having the ability, we didn’t need to do this, to trade 100% of US equity flows. And we did that in less than one week. Now, to accomplish that, it wasn’t just Citadel Securities, brilliance or leadership. We needed a heck of a lot of support from the local community, infrastructure around the technology we run, broadband and Wi-Fi access, a bunch of other things, brave people who worked with us in the bubble that we created. I should highlight we wanted to keep our own people and everyone else who was supporting us safe and secure. So, we created this COVID bubble in the four seasons in Palm Beach. It worked incredibly well and I say that was a part of our origin story. That really was the entry point for Citadel in Florida. Our people got there. The sun is shining. It’s an incredibly vibrant place. The beach is right there. What’s not to like? These were people who were working in Chicago at the time. Um, and so many, if not most of our people in that Florida COVID bubble fell in love with it. And again, going back to the partnership, public and private, it served us incredibly well. We then decided for a bunch of reasons, Miami is going to be the destination and off, you know, we went running and here we are. Last thing I’ll say about that experience, if any of you have been or happen to go to the Four Seasons in Palm Beach, you can send me a thank you note. I think to this day the Four Seasons Palm Beach has the best and fastest Wi-Fi service of any hotel around the globe. And that is a true story. Thing such a great an amazing story just you talking about that whole can do attitude I think really as you know reflective embodied terms of what how Miamians and South Floridians think.

Jon Hartley: I want to sort of pivot a little bit to global markets here in in the global economy. I mean, how would you characterize the currency of the economy and markets? I mean, we’ve got tariff uncertainties back a bit. We got, you know, public debt as a fraction of GDP is high in the US and in many advanced economies. AI seems to be disrupting one industry after another. Are you constructive on markets right now or are you defensive?

Jim Esposito: I think the foundation of the current global economy is incredibly strong. We might actually be in a Goldilocks scenario right now. We’re seeing robust economic growth, reasonably low inflation, and um you know, we’re seeing an ability right now to lever technology, not just at a place like Citadel, but in the real economy, that leaves us very constructive and very optimistic. Now against that strong foundation and backdrop there’s a lot of fragility a lot of uncertainty geopolitics obviously the divisiveness that we see in our own country makes the world both fragile and complicated. Now, Jon, you said it. I think ultimately now we’re in a foot race between the growing stock of US debt and the amount of money that it costs, the growing money that it costs to service that debt versus what is an ever accelerating pace of change and productivity gains brought about by AI. I think the optimistic scenario is we can grow our way out of this that AI is going to lead to sufficient productivity gains that stock of debt won’t become a problem. If somehow AI fails us and we don’t achieve the productivity gains that might be priced in right now at some point in the future we’ll have a real existential moment. I’m not at all suggesting that’s imminent. I’m not at all suggesting we have to face that moment. But this foot race between productivity gains brought about by technology and what has been you know a lack of discipline in terms of cutting back government spending. That’s where we are. Last point that I’d raise probably more just a personal view but all of you have lived this alongside of me. I would just remind the group you know the last 15 years certainly true in this country but it’s also true around the globe has really been an abnormal artificial period and you think about the 2008 global financial crisis. The amount of both monetary and fiscal stimulus and accommodation that was pumped into markets. We got an extra big dose of that during the COVID period. we got another dose of that, you know, at the end of the Biden administration. I think we’ve probably lost a certain amount of discipline in financial markets. If you’re an investor, buying the dip has made, you know, all the sense in the world because there’s always been a government back stop or put and there’s been no penalty for making mistakes. There’s been no penalties for being undisciplined. Generally, and I’m simplifying, I think every type of investor is stretched one, two, three categories out further on the risk spectrum than he or she maybe needs to be because we’ve lacked a discipline from this extraordinary abnormal artificial period. So far, we’ve managed to take interest rates that were negative for a period of time, then they hovered around zero for a period of time up to a slightly more normal level. But I still worry about how do we wean markets off the sugar rush that was needed for a period of time, but potentially with the benefit of hindsight now was either too much or too long. I’m not sure we’ve completely walked to the final end of that tight rope and I think markets are still grappling with that as well. So foundation incredibly strong almost goldilocks but the picture around that foundation very complicated very fragile

Jon Hartley: So I want to talk more about AI you can’t really pick up the newspaper on any given day and not hear about AI in some way tons of capital expenditure on the part of hyperscalers you’ve got you know questions about potential labor market effects of these incredible new tools that seem to be coming out every day. You know whether it’s Claude code or many of these other you know agentic AI applications there’s you know questions about you hallucinations you the list goes on. Where do you think we’re at in this AI journey right now?

Jim Esposito: Well we’re definitely in the very early innings, but to your point, most recently, you know, some of the large language model releases and you reference Claude, very significant, game-changing, transformational, and so when I say we’re in early innings, but we’re about to ride a wave like one we’ve never seen before. Um, and look, I I think you pull on that string and you can get to, you know, some pretty heady interesting societal debates. , some of them are playing out this week in the general press. Um, you know, I mentioned something about our love for the state of Florida and Miami because I think, you know, local officials, policy makers have partnered with us in the private sector well on this AI debate. At a minimum, I think we need to start to have these types of discussions. And so I don’t subscribe to a way of thinking or a view that none of us are going to have jobs or the machines are going to do everything for us. But if there were ever a period in history where we should be discussing upskilling and education and building a labor force fit for purpose in a world where we’re heading into autonomous driving. I see many Waymos, you know, cruising around Miami. I mean, you’ll be in touch, but trust me, it’s coming to a theater near you. The physical manifestation of AI is going to be robotics. You know, if you go to China, if you go out to Silicon Valley and get a proper demonstration about where robotics are heading, it’s mind-blowing. And so we have to set up our labor force by the way for the most entry level for you know more mundane task manual labor jobs but right up to the most important white collar jobs. It’s going to require bold imagination and a rethinking about how the labor force comes together equally on college campuses and what we’re teaching our kids. This stuff’s going to matter. And so if I worry about anything going back to the, you know, where are markets and where is the economy, I worry a lot about this, not because I don’t think the problem can get solved. I worry because we’re not even having a debate yet. And I think that’s wrong. And so we’re going to have to think long and hard about that. So we have some wood to chop in that regard. Um, look, AI is going to change everything we do as individuals and humans we have to stay ahead of these trends as business leaders and we’ll talk about this I’m sure you have to start thinking about where and how you can use these tools again I said this but ours is a company founded on these principles first on technology generally then on many machine learning large language model applications but I think it’s obvious to the audience if there’s any company in Florida that’s leveraging AI, it’s a place like Citadel and we definitely are having wins and gains as a result. So I want to talk to me a little bit more about the AI labor market effects. I mean is AI in your mind a positive or a negative for jobs sort of in society at large? And what about in in finance? I mean, we, you know, I think we’ve seen these sort of news reports from time to time that say, you know, that invest investment banks are cutting their analyst jobs by half because of AI. I mean, what what would you tell young people today about how to maybe AI proof their skills and career prospects if they were thinking about entering a career in finance or another industry? So, a lot there. Um, look, I think there’ll be more of let’s let’s stick to financial services compared Citadel Securities to the big banks at Citadel Securities, we have really no strategic plan to cut heads because we’re using AI in a more profound way. But I suggested earlier we had already achieved a lot of that technology dividend. So for us AI is all about getting more efficient, more productive, running bigger and more robust financial models. You know the speed by which we can do certain things that really fuel and power our um our strategies and our you know our our client-f facing franchise. If we used to reunderwite the big risk models that power Citadel securities four times a year because that was about the amount of technology and computing power that could handle that. We’re now capable of doing that 12 times a year and going from 4 to 12 leads to not only efficiency gains, more revenue and more profit falls to our bottom line as a result. So for the avoidance of doubt, AI has been very additive to our bottom line. But for us, it’s not at all a headcount issue. Um, now in the rest of financial services, it goes back to what I said earlier, I think there you’ll see a more material reshuffle of what people do. There are many many tasks at the big banks that can should and will get automated. Um I don’t know if it’ll be in the next 12 months or 5 years from now but that will happen. I don’t know if that means banks will have materially smaller headcounts. I think the jobs of the future will be more about people applying real thought, reasoning, intuition and you know coming up with big bold ideas. And it goes back to the point I made about, you know, making sure colleges keep up with this, right? And so, you know, what’s going to equip people against, you know, the potential job shrinkage that could come from AI? You know, I don’t know if I have any great wisdom to impart, but I think educating well-rounded, thoughtful, articulate people, is going to be more important than ever before. Um, and so I think it’s going to be things like that that people need to get focused on in a hurry. I do think these changes, as I said, are coming to a theater near you very, very soon. Um, and if you run a small business, a big business, I think you have to be obsessed right now about what you’re going to do with AI, what your competitors are doing with it, and it should be a part of the leadership group of that company’s time. At Citadel Securities, at Citadel, we don’t have an AI department. In fact, I could be wrong, but I don’t think anyone at our company has the title head of AI, the way we think about it is every one of us, everyone in the leadership group, every employee is tasked with thinking about what does he or she do on a daily basis. What are your operational workflows? Think about them, map them, break it down to the very, very granular level. and then look at where you can disrupt yourself in that example by using AI and that’s how you start to get a productivity lift. That’s how you start to incorporate AI. A topsdown approach has been failing many large companies. If you think AI is off to the side in a different department and you call them on some helpline on a 1-800 number, you’re missing it. I think you’re really really missing it. This is definitively a bottoms up granular analysis of operational workflows. And when you start to do that work, I think you start to actually almost immediately get some real productivity gains.

Jon Hartley: That’s fantastic and really you know, we’ve got so many people here who I think are much like yourself coming from New York in finance or elsewhere. And so I think it’s really fantastic hearing I think from yourself in terms of how should people be leveraging AI in their businesses or or day-to-day work. It’s really a real treat to to have you here Jim and really want to thank you for coming. This has been a real honor speaking with you and really want to thank you for this fantastic conversation. Thank you.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Tevi, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom of the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Tevi Troy, who is a presidential historian, has a PhD in American Civilization from the University of Texas at Austin. He’s a former White House deputy on the Domestic Policy Council and former Deputy Secretary of Health and Human Services during the George W. Bush administration, and he’s currently a senior fellow at the Reagan Institute and a senior scholar at Yeshiva University’s Straus Center. He’s also the recent author of “The Power and the Money: Epic Clashes Between Commanders-in-Chief and Titans of Industry.” Welcome, Tevi, thanks so much for joining us. Really excited to have you on.

Tevi Troy: Jon, I’m thrilled to be here. I really do enjoy listening to your podcast. You have these great economists on, and you go in-depth about their careers, and their thoughts, and how they advance the ball in their areas of expertise. You do a really great service with this podcast, so thank you for having me on.

Jon Hartley: Well, thanks so much for having me. I’m really excited to talk to you about you and your career. So, first, I want to get into your own personal history. You grew up in Queens. Tell us how you got interested in presidential history, intellectual conservatism. And also how you stumbled on, sort of, this interesting dynamic between titans of business and presidents over time. How did you get interested in all this?

Tevi Troy: Sure. Well, as you said, I did grow up in Queens in the 1970s. It was kind of a rough time. High crime, graffiti, inflation, uncertainty about America’s place in the world, and I was from a family that was very patriotic. We were descended from European Jews who had escaped from Europe, and if my ancestors had not left Europe, they probably would have died in all the various tumults of the 20th century, whether it was in Soviet Russia or Nazi Germany. And so we were very grateful and appreciative of this country. I still remember my mother would take me into the voting booth with her to show me how to vote, and it was a real point of pride back when you actually voted on Election Day, which I still think was a good thing, and brought a measure of national unity. This is the day when we all vote. I think that was an important thing. My dad was a history teacher, so I had a love of history from him. And… when I graduated college, I went to Cornell, I wanted to see if there’s a way to try to make things better, to give something back to this great country that I love so much and I was so grateful for. And I gravitated to Washington. My first job in Washington was working at the American Enterprise Institute, a think tank your listeners will know well, and I had the privilege of working for Ben Wattenberg. Ben was a former Lyndon Johnson speechwriter who was really immersed in data and demographics and statistics, and so I learned how to use statistics and numbers to marshal an argument from him. Ben was also a neoconservative, so he had grown up a Democrat, was a proud Democrat, and then he didn’t like where the Democratic Party was going, and he was trying to reform the party from within, but the party was moving so far left, and he said he was just staying where he was. He became known in the 1980s as Ronald Reagan’s favorite Democrat. And I also looked around the American Enterprise Institute, and I saw these titans, not just Wattenberg, but Judge Bork, and Jeane Kirkpatrick. And Irving Kristol was there, and I was just amazed at how impressive these people were, but also by the influence they had. They were able to shape the debate. They were able to go out there and define what American policy was through their conversations with senators and congressmen and cabinet members. And I wanted to do that. I thought that was really cool, what they did. So, in the days before LinkedIn and before the internet, I tried to isolate what they had done to become what they were. I was a 22-year-old. You either have the natural smarts or you don’t, but I didn’t have the external things, the attributes that you acquire. And I tried to figure out what they had acquired along the way. And what I found, for the most part, from these people at the senior levels of think tanks, were that they had three things. Number one is they usually had some kind of advanced degree. Number two is they had some kind of book or article that helped make their name. And number three is they usually had some kind of senior government service. Obviously, Judge Bork had been a judge, and Jeane Kirkpatrick had been ambassador to the United Nations. Ben had worked as an LBJ speechwriter. And I said, I’m gonna go try and do those things. My first step was to get a graduate degree, as you said earlier. I went to Austin, Texas, to get a PhD in American Civilization. While I was there, I studied with Elspeth Rostow. She was the wife of Walt Rostow, who was Kennedy’s National Security Advisor, and also Johnson’s National Security Advisor. And I learned so much about the presidency from her, but also from talking to Walt Rostow, who’d been the National Security Advisor. It was really my first encounter with people who’d been in the White House orbit. This was in the legendary Kennedy administration. So, I went there, got my PhD, I wrote a dissertation that I hoped I could publish as a book, and I did. It was my first book. It was called “Intellectuals and the American Presidency,” and it looked at intellectuals who worked in the White House for various presidents, people like Arthur Schlesinger under Kennedy, Daniel Patrick Moynihan -- he worked under Johnson, but then he was the White House intellectual under Nixon, and then Marty Anderson, who is known to Hoover people, because he was both in the Nixon White House, but then he was the domestic policy advisor under Ronald Reagan. So, I wrote that book, and then I had the opportunity to work in government myself. I started out on the Hill working for the great Christopher Cox, a very smart California congressman with a lot of talent and a lot of ambition. and a real serious conservative. Then I worked for John Ashcroft, a senator from Missouri. He was thinking about running for president. That didn’t work out, but it was a good experience working for him. And then I joined the Bush administration, where I had a number of jobs, starting at the Department of Labor. I was Deputy Assistant Secretary for Policy, which is the office that Pat Moynihan worked in when he was in the Johnson administration. Then I went over to the White House in a variety of jobs, including, as you said, the number two at the Domestic Policy Council, and eventually I became the Deputy Secretary at Health and Human Services. So that was my journey through government, and then I had done all those things that I’d set out to do, meaning I had the PhD, wrote a book… a dissertation that became a book and was published and got some good reviews. And then I served in government, and I said, I’ve put these things together, now I want to build that think tank life. And since then, I’ve worked at a number of think tanks, I’ve worked at the Hudson Institute, Mercatus Institute. I started a think tank for a while called the American Health Policy Institute, I worked at the Bipartisan Policy Center, and now I’m with the Ronald Reagan Institute, which is really a great fit because I’m so committed to the ideas of Ronald Reagan, and it’s a terrific place with some great leadership, people like Dave Trulio, who’s at the head of the whole operation, and then Roger Zakheim, who runs the Institute. And I write books, and I write a lot of articles, and… I relish having some opportunity to try and shape the debate in a positive way, to try and put ideas out there based on my experience and my knowledge of history.

Jon Hartley: Well, it’s fascinating, I mean, your career’s been amazing, and we’ll talk about some of your books, just in a few minutes here, but I want to first talk to you and just help our, you know, listeners and viewers get a better sense of how some of these policy functions within the White House, within the administration, how they work. You worked on the Domestic Policy Council. I’m just curious, you recently wrote a National Affairs article on the history of what are called Policy Coordination Councils, the Domestic Policy Council is one of them, the National Economic Council is another, the National Security Council is also a White House Policy Council as well. You wrote this article, How the White House Makes Policy. And it’s interesting, because all these policy councils, these policy coordination councils were really built after the Second World War. They aren’t in the Constitution, unlike, you know, obviously that the cabinet secretaries are there, and I mean, to some degree, and I think we’ve seen over time some conflict between the policy coordination councils and the cabinet secretaries, but I’m just curious, could you explain how exactly they work? in conjunction with the entire White House chain of command, and how they actually get things done when it comes time to legislation or executive orders.

Tevi Troy: Yeah, it’s a great question, and the full answer is in my, probably, 7,000-word piece in National Affairs, so I will give a shorter version of that here. But first, let me say a couple of things. You are correct that there’s no constitutional basis for these councils. There’s also no legislative basis for these councils. They are wholly the product of the President and the Presidency. I guess there was an exception in the National Security Council, which was the first one, but really, the President establishes these, and can de-establish them. So I think that’s the first thing to think about. The second thing is that I’m grateful to National Affairs and its editor, Yuval Levin, who worked for me, actually, in the White House back in the George W. Bush days, for having a magazine where you can explore these issues. It’s obviously modeled after the Public Interest, which was Irving Kristol’s great publication. Irving used to say that it only had 6,000 subscribers, but they were the right 6,000. And now, with the internet and some savvy article writing, Yuval’s pieces can get… or pieces in Yuval’s magazine can get read by many, many more people than just those 6,000. So, National Affairs is a very important institution that allows us to explore questions of governance, like the one I looked into about the policy councils, because nobody really has done this kind of deep dive into the policy councils. They did start with the National Security Council, which is part of Truman’s effort to find a way to manage the Cold War. You’ve got the State Department trying to manage diplomatic relations, and you’ve got the Defense Department doing the military stuff, and then you’ve got the newly created CIA, and there’s all these different pieces moving around, and the National Security Council is designed to coordinate all these different pieces so that they’re at least moving to some degree in the same direction to the extent that’s possible in the behemoth of a government that we have. It’s modeled after a committee that the British had to help run World War II, and the Americans saw that that was a valuable way of letting Churchill understand what was going on in the various parts of his government, and so we brought that model in to the U.S. to create the National Security Council. Then it takes a while, but we then create a similar Coordinating Council for Domestic Policy. It was originally called the Office of Policy Development, and it is really the ancestor of what becomes first the Domestic Policy Council, and then it’s broken up into two things, the Domestic Policy Council and the National Economic Council. There are often political circumstances that come behind these creations. National Economic Council was part of Bill Clinton’s effort to show that he was fulfilling his campaign promise of focusing like a laser on the economy. And he said by creating this separate entity, this National Economic Council, it would show us a level of focus on the economy. And then sometimes there’s external circumstances that lead to the creation of these things. The Homeland Security Council was founded in the aftermath of 9-11, when it was founded because the U.S. wasn’t really paying attention sufficiently to threats be they terror threats or natural disaster threats, and the National Security Council wasn’t quite the right fit for some of these types of threats, specifically the National Disaster ones. I remember Steve Hadley, who was the National Security Advisor under Bush, his attitude was. I don’t know anything about hurricanes, why should I be following that kind of issue? So. The way we have it is there’s basically four councils now, the National Security Council, Homeland Security Council, National Economic Council, and Domestic Policy Council. The reason I wrote my article was in part because the Biden administration created something called a Gender Policy Council. And I really see no reason for this council. Most of the issues are actually handled by the Domestic Policy Council, and creating extra councils just creates extra opportunities for strife. You talked about my books. One of my books is Fight House, about infighting in the White House, and you want to create these institutions in the White House that can limit infighting and coordinate and get better decision making, but if you have competing power centers, that actually leads to more fighting, so it’s almost counterproductive. You’ve got to have some of these. You had to have a National Economic Council and Domestic Policy Council, even though sometimes there’s tension between them. But if you have too many policy councils, you start to worry who’s minding the store, and people really will get in each other’s playpens and cause trouble with one another. So, these councils, I described it when I was… when I was running the Domestic Policy Council, I described it as you’re kind of like a station manager in a train system. There are all these trains moving at various paces, and these trains are policy questions. Now, Colin Powell has said that the easy decisions, the 90-10 decisions, get made At the local level, by career officials. And then the harder the decisions are, the more they gravitate upwards. Some get done in the regional offices, some get done by political appointees, some get done by political appointees in Washington. The harder decisions gravitate to the White House. And then the hardest, hardest decisions, what Powell called the 49.5 to 50.5 decisions. Those decisions have to get made by the President in the Oval Office. So, as this coordinator for a policy council, you’re trying to decide which decisions can get made where, how quickly they have to be made. Which trains make it into the station at what time. And then, once that happens. There’s a three-level system of meetings at the White House that determine policy. There’s the PCC, which is a policy coordinating committee, then there’s deputies. Where the deputies get together, decide things, then there’s principals. And after all those, if nothing is resolved, then it goes to the president for a decision. That’s called policy time. And a lot goes into that. You have to write a memo to the president. Remember we mentioned Yuval worked for me. I would have to approve all these memos before they moved forward, and I would do this at 8 or 9 at night, after I was through a full day of meetings from 7 a.m. to 7 p.m. at the White House. And I’d always take Yuval’s memos and put them at the bottom of the stack, because I knew they wouldn’t need any editing, because he was so good. So I knew when I got to Yuval’s memo, I was almost ready to go home, because his memo would be a joy to read, and not something I had to take a red pen to. And so you have to have these memos that go to the president, you have to decide who’s in the meeting. with the president. A lot of people think they should be in the meeting with the president, but they shouldn’t all be. On the other hand, if you have too few people, you might be squelching dissent from somewhere. You may not be having the right people to raise different sides of the argument. You also, you don’t want to have a full-down, full-on knockout, drag-down fight in front of the president. You want to have some sense of what the issues are, lay them out in the memo, make sure the people who are going to have the argument will do so in a respectful way. And then the important thing, and this is something I learned from Karl Rove. is you can have the biggest fights, you can have the biggest disagreements, but once the president makes the decision, you’ve got to walk out of that room in lockstep with your adversaries, meaning the other aides with whom you disagreed with on that issue. You might be allies on a different issue, but you’ve got to walk out of that room in lockstep behind the president’s decision. And that really is, in a nutshell, as I said, it’s a 7,000-word piece, but in a nutshell, that’s what the policy councils do. They try to tee up decisions for the president, so the president gets… the president makes decisions. with full information, in a timely manner, and in ways that have all the appropriate voices heard, so that they’re not going to be sniping to the press afterwards. I didn’t get my say.

Jon Hartley: That’s fascinating. I totally understand that the sort of, I guess, the conflict that exists between these, coordination councils. I think at some level, the NEC has displaced what the Council of economic advisors, the role that it played prior to the 1990s. It still plays a significant role, but there’s now sort of competing tensions, and the Council of Economic Advisors does more analysis now, and NEC does a bit more policy now, but I’m just curious about the relationship between the Policy Coordination Councils and the Cabinet Secretaries, because I know that Colin Powell famously said that For example, the Policy Coordination Council directors are kind of like a chief of staff. To the cabinet secretaries, but I understand that I think some policy council directors, in some respects, feel like the cabinet secretaries. at some level, report to them. So I’m just curious how this reporting structure sort of works. I know, for example, with the chain of command and defense, It’s very clear that it goes from the President to the Secretary of Defense. And then, on down, on down the chain, the various command center, commanders and so forth. But I’m curious, my understanding is that there’s been a lot of conflict between these people in the past, but You also worked as the Deputy Secretary at HHS, which is an agency and has A Secretary. So I’m just curious if you’ve seen, also, from the agency side, how there’s input from, an agency and how that goes to the White House and that interaction there.

Tevi Troy: Well, first of all, I knew Colin Powell, and he was very smart about the mechanics of government and how government works, and he was a very skilled bureaucratic player. But if he said that the policy councils were like chiefs of staff to the cabinet secretaries. he was wrong. And I’m not even sure he said that, because it doesn’t sound like it, because the point, the whole point is that the head of the National Security Council is supposed to coordinate between state and defense and CIA and all the agencies that have some kind of national security insight. And you can’t be chief of staff to one agency and be head of the National Security Council, because you have to weigh these competing tendencies, these competing interests, and these competing personalities. And I think Powell is actually there at one of the perhaps, worst managed periods of national security coordination, which was in the Bush 43 years, because you had a problem there, and again, I’m a big fan of George W. Bush. I think he did a good job coordinating on the domestic side, but that’s where his strengths were. He was a former governor of Texas, he knew the domestic issues. On the foreign policy side, he was less certain of himself when he came into office. That’s why he picked Dick Cheney, who had a lot of foreign policy background. to be his vice president. That’s why he picked big dogs, people like Colin Powell and Don Rumsfeld, who had more experience in foreign policy than he, to be those key cabinet secretaries. But the problem was. That when you pick all these big dogs, the big dogs often fight with one another, and he picked Condi Rice, with whom he was very close. to be the National Security Adviser. She, again, is a very talented person, obviously the head of Hoover, where you work, but she was more junior to a lot of these people, and that put her in a tough position, and she would tell the president, these people are fighting, what do I do? And he would say, you’re the National Security Council Adviser, you have to work it out. Which was putting her in a tough spot. So, there was a lot of infighting between those groups. especially between state and defense, the vice president’s office was also involved. So, it’s a lot more than just the chief of staff to one agency. These council heads really have to coordinate and manage the tensions between agencies, and I think that’s a better way of looking at it.

Jon Hartley: It’s fascinating. I heard this from General Mattis, the story about Colin Powell, and even in the Trump administration, or the first Trump administration, for example, H.R. McMaster, who’s running the National Security Council and Mass, and… It’s just very interesting seeing how there’s this new idea of policy coordination councils, and that’s, in sort of long-run history, it’s something that’s new, and I guess, something that can cause some tension. I want to get into your books, because I think they’re really, fascinating, and…

Tevi Troy: Before we do that, can we just… I just want to briefly talk about the National Economic Council versus the CEA.

Jon Hartley: Absolutely.

Tevi Troy: Because that is something that people get wrong all the time.

Jon Hartley: And I just want to lay out what the two councils do. The CEA is created by Congress, actually. It’s the Employment Act, 1946.

Tevi Troy: And it has a Senate-confirmed head, the Chairman of the Council of Economic Advisors, And that is… designed to provide full economic information from economic experts for the president, and it’s not even often that partisan in office, and I remember listening to your great interview with David Henderson, where he talked about how Paul Krugman was in the Reagan White House CEA, and so sometimes you’ll have people on different sides of the aisle, but these are Well, Krugman aside, these are usually skilled economists who are not too partisan, but… the whole point of the CEA is to give the president better economic information. the point of the NEC, which is a different entity, and I know sometimes the CEA and NEC heads fight, but the NEC person is supposed to be a referee between competing interests within the economic policy-making realm, including CEA, but also including Treasury, and including OMB, and including Department of Commerce. And the head of the NEC isn’t necessarily supposed to have his thumb on the scale. These advisors provide advice to the president, and the NEC coordinator is supposed to create a forum in which they can have this done. Now, it doesn’t mean there always aren’t… they aren’t always like that. I mean, Larry Summers always would have his thumb on the scale, but the idea is that the NEC is supposed to be the referee, just like the head of the DPC is supposed to be the referee… the referee, where they bring these ideas, these issues to the president. Now, the president can ask. the head of the DPC or the head of the NEC, well, what do you think? And that’s fine, but they should be setting up a fair conversation for the President and the President’s advisors to hear the competing questions and competing interests And then the president can make an informed decision. And I… I can’t believe I actually interrupted you when you were about to ask about my book, so I’m always happy to talk about my books, but I really wanted to get that out there.

Jon Hartley: Well, that’s fascinating, just about the NEC/CEA and, a long, long history there, too. Many CEA chairs over time, Marty Feldstein, CEA, I think under Reagan, had Larry Summers, and Paul Krugman, and, and many others. John Cochrane, Greg Mankiw, they were all… it’s, it’s pretty, pretty impressive.

Tevi Troy: Basically, some of our best-known economists have worked at the CEA.

Jon Hartley: Absolutely. And so, I just want to pivot to some of your books here, because some of them, I think, are really interesting.

Tevi Troy: All of them, actually.

Jon Hartley: All of them are very interesting. I think some, in particular, just on this topic of, sort of the relationship between business and, and, business titans in the White House, your most recent book. You’ve written a lot of amazing books on the American presidency, including “Intellectuals in the American Presidency,” “Shall We Wake the President,” “Fight House,” “What Jefferson Read, Ike Watched, and Obama Tweeted.” Most recently. The Power and the Money: Epic Clashes Between Commanders-in-Chief and Titans of Industry. I’m just curious, what have you learned about the Office of the Presidency in writing all these books?

Tevi Troy: That’s a great question. I’ve learned so much more about the presidency than I knew when I worked in the White House, and I knew a lot, because I had already been a PhD and had studied the presidency, so… it really has helped inform my knowledge, understanding of the office, the history. One person joked to me, you have a presidential story for every occasion, and I kind of do. I like to throw presidential stories out there. But in each of my books, I’ve written 5 books on the presidency, as you said. In each of my books, I’m trying to address the question of presidents and blank. And the blank is something that has not yet been covered with respect to the presidency. But also, I’m not just trying to do trivia here, so I don’t do presidents and their dogs, for example, although that’s fine if you want to do that.

Jon Hartley: a good book.

Tevi Troy: It’d be fine. But it’s been done, by the way. But… I’m trying to do something that answers the question of where we are in 21st century America. Something about the blank, applying it to the presidents that can inform us about this country at this time. That’s why Power and the Money struck such a resonant note. It was coming out at the right time when you had Elon Musk advising the president on DOGE, and you have these corporate titans who are more important than ever in what’s going on in Washington, but government’s more important in what they do, and whether they can be successful in their businesses. I wrote “Fight House” at a time when there was a lot of tension within the Trump administration and infighting, and I showed that there had been infighting in many previous administrations. So, with all my books, I’m trying to get to a larger question of where we are in 21st century America, even as I explore Some new aspect of the presidency that hasn’t really been delved into by previous historians.

Jon Hartley: It’s fascinating, and they’re all really terrific. So, I want to focus a little bit more on just your most recent book, “The Power and the Money” you’re cataloging a lot of relationships between business people and the presidency over the years, and it starts sort of in the late 1800s, with the rise of these big tycoons, the Rockefellers, the Carnegies, the JP Morgans. Let’s start there. There were a lot of examples of JP Morgan, who was involved in the 1907 bailout, and the U.S. created the Federal Reserve almost in response to that, in the sense that they didn’t want to rely on private actors as a lender of last resort. But then you also have Rockefeller and Standard Oil around that time, the rise of antitrust. And trust-busting under Teddy Roosevelt. I’m curious, what was going on at that time in terms of how these titans were interacting with presidents? Were they donors? What was exactly going on? And, And I guess, what was the sentiment around folks like Teddy Roosevelt that, obviously, we’re taking a very heavy-handed approach with, breaking up, many of these very large firms, the Standard Oils of the world, and applying the Sherman Act, and all these antitrust. Laws that were being passed around that time.

Tevi Troy: Yeah, it’s a great question, and it’s really that period that got me interested in this topic. I was obviously seeing a lot of parallels between today and what was happening in the late 19th century. And what you have in the late 19th century is the rise of these new industries, industries that don’t exist before, railroads, oil. And government has no mechanism for trying to rein them in if… rein them in if they so desire. They may not desire, but there’s no mechanism if they do. And so you have… You have Rockefeller. Who comes from nowhere, builds this massive empire in a 10-year period, from 1870 to 1880. he creates Standard Oil. It’s interesting, the name Standard Oil is because he was trying to create a standard for what oil should be. At the time, oil was combustible, unreliable, you didn’t know what you were going to get when you purchased it, but you knew if you got a standard oil. shipment of oil, it was going to be reliable. And so he was, in many ways, a regulator himself. It was a private sector form of regulation. You knew you were getting a reliable product if you were getting it from Rockefeller. It doesn’t mean he was the nicest guy and obviously had some sharp-elbowed business practices, but what he was trying to do was create a standard for what oil should be, and he did. he builds this empire over a 10-year period, and in the beginning of 1880, he has 90% of refining capacity in the U.S. Massive empire, complete control over prices, over everything. And there are presidents who look at these trusts and start complaining, including Ulysses S. Grant, but they have no power to do anything about it. And it’s only in 1890, when the Sherman Antitrust Act passes, that suddenly there’s something that government can do. It has its first arrow in the quiver, if you will. But… having a law and having it enforced are different things. You don’t really have any presidents who are so interested in pursuing this until Teddy Roosevelt, when he comes to power. And it’s important to remember that Teddy Roosevelt was kind of an accidental president. was made vice president because he was seen as such a pain by forces in New York, including the Standard Oil people. They said, let’s make him vice president, get him out of the way. And then the thought is, he’s working for McKinley, who’s a vigorous, young, powerful president, and McKinley is shot. And when McKinley dies, and they didn’t even think McKinley was going to die initially, but then he does die from his wounds. then Roosevelt becomes president, and I think it was Mark Hannah who said, that damn cowboy’s now in the White House. So, Roosevelt’s now in the White House, and he is of a much more progressive bent than McKinley or the Republican Party panjandrums who put him forward. And… he wants to make changes, and he sees the Sherman Antitrust Act, and he creates the Bureau of Corporations, and he has all these possibilities for reining in companies, and he sees the value in making Rockefeller his villain, his target, if you will, and Rockefeller, at this point, is already retired from the day-to-day management of the company, but that doesn’t matter. Roosevelt sees the value in using Rockefeller as a symbol of all that is evil in these new corporations. And he starts the process by which Standard Oil is eventually broken up. He doesn’t see the breakup as president himself, because that happens under his successor, William Howard Taft. But it does happen in his lifetime, and it really is an initiative that he started. And… Rockefeller, for all these years while he was amassing all this power, he never really paid attention to government, because he didn’t think government was that important. And for most of his career, he was right, but this happens a lot of time with innovators. They are frozen in time at the time when they grew up in the business, and they see things at that moment, and they’ll always tell stories of, well, when I was growing up, I did this and that, but It’s not always applicable when the government rules change, and what happened was, over the course of his lifetime, the government rules changed, government got more power, government got more tools. And suddenly, government was a threat to his company, and he recognized it too late. There’s actually a theme in “The Power and the Money,” where I talk about multiple CEOs who thought that they didn’t have to worry about government, and then government came for them, and they either had to adjust, change tack, and become more involved, or they They suffered, or sometimes they suffered, and then they got more involved.

Jon Hartley: It’s, fascinating. And I guess just moving forward here, in history, to sort of the more the… early 20th to mid-20th century, the whole concept of government really changes in the U.S, from this sort of Madisonian sort of concept to. what really, I think a lot of the progressives envisioned. So you have the 16th Amendment, which introduces the income tax. You’ve got, obviously 1929, the collapse in the stock market in the U.S, falling by almost 80-90%. you’ve got the Great Depression, you’ve got the enormous growth of government during the FDR era. And also this sort of idea that began even earlier, which is sort of this reliance on experts, and this is sort of what leads to the rise of the administrative state. So, I’m just curious, what’s going on during this time? Where we sort of shift from having, a government, including the Supreme Court, that in general is ruling, making many sort of favorable pro-business rulings to. this era of FDR and other progressives like Woodrow Wilson, as well as Teddy Roosevelt, who’s sort of a progressive to some of these others, but with the whole concept of government changes, and in many respects, government experts are given lots of power in making regulation, and so forth. I’m just curious, how was business responding to that at the time? How are these business titans responding to that? Obviously, many were not fans of FDR, but I’m just curious, what was going on amongst the business leaders during this time? Obviously, there was a lot happening, you had the rise of the auto industry, Henry Ford, you had the rise of the banks. obviously, JP Morgan, and I think that was broken up. You had Morgan Stanley. You had, and JP Morgan, what it’s known as today, but they were at one point, one company. You had, for example, Glass-Steagall, which was separating commercial banking from investment banking. There was a lot going on in that period, and I’m just curious, what were the sort of stories That you include in your book, or that you researched about when you were talking about this period?

Tevi Troy: Well, first of all, it’s important to remember that business is always against regulation until they see it’s inevitable, and then they want to be part of the shaping of the regulation. And in… In doing so, what they do is create a barrier to entry for other smaller potential entrants. And, as you know, complexity is a subsidy. The more complex you make the environment, the more expensive it is to get into an area and get into an industry. And so the big businesses can afford the lobbyists to shape the regulation. They can afford the lawyers to tell them how to deal with the regulation. They can afford the personnel costs that HR regulations impose, and so it’s easier for them to have a regulated environment, even though you could say, a regulation costs a company billions of dollars a year, but yeah, they have the billions. And a smaller entrant that’s trying to get in, they say, I can’t deal with all this paperwork, and they just give up, and then they go work for the bigger corporation, because they can’t cope with all the regulatory imposition. So. I think that is a recurring tension and a recurring theme in American life that I see. And I also talk about how, since you had that first incursion, if you will, the the Sherman Antitrust Act. Since then, you’ve seen government get more and more involved. In fact, I have an amazing appendix in my book where I show what I call the end of the white space. when Rockefeller comes in, he has a blank slate. He can operate without regulation, other than the regulation he imposes on his own standard of what oil should be. But over time. Government has more and more regulations, more and more agencies, more and more legislation, and business becomes more and more constrained. That doesn’t mean they can’t make a profit. They make huge profits. But they do so in many ways today. almost at the behest of government. Government’s telling them how many people they can hire, and at what wages, and what demographic characteristics of the people they should hire can be, and where they can sell their product, and are there tariffs on the products, and what they can do with their environmental offshoots, and so many things are governed by government. often to try and attain certain social goods. And businesses are, in some ways, the enabler, the participant with the government in doing this. So, it’s not just… business thinks regulation bad, business wants toget rid of regulation. It’s business recognizes that government is there, and they need To find strategies for not only dealing with the regulations that exist, but also shaping the regulations in ways that help them, and often that don’t help either their competitor or the new entrants into the labor market.

Jon Hartley: But it’s, fascinating, and, fast-forwarding a little bit more, in this mid-20th century period, we’ve got, Detroit ends up becoming, One of the largest cities in America, has the highest per capita incomes out of any metropolitan area. Hard to believe that now, sort of 75 years or so later. But, you’ve got also the rise of business groups like the Chamber of Commerce and Business Roundtable. You’ve got the rise of unions, represented by these big, conglomerates like AFL-CIO. You also have mega-donors that are often being the heads of these various company fortunes. I’m just curious, what exactly are the sort of business versus labor dynamics at the height of union power looking like? And obviously, unions have changed enormously since the fraction of workers, of private sector workers that are affiliated with the union now are, I think, less than 10% of the American workforce, down from much higher numbers into the mid-20th century, but I’m just curious how How’s that dynamic really, shifted a lot, and what were sort of the business titans saying, or in terms of their interactions with the president. Any particular stories that were interesting at all? I think Henry Ford’s mentioned in your book. There’s many others that are interesting, that are mentioned in your book as well, What was going on sort of behind the scenes with the presidents, over those years?

Tevi Troy: Yeah, there’s a lot going on there, and… I talk about multiple auto executives. I’d say there are 3 key automotive CEOs in my book. First, there’s Henry Ford, and he grows up in this era where it’s relatively light regulation. when the New Deal comes around, he’s very angry and bitter about it, he hates Franklin Roosevelt, although he does make some kind of accommodation with Roosevelt when World War II comes about, and the U.S. needs to build up its industrial armaments, and he creates the largest armaments factory in the world at Willow Run, and Franklin Roosevelt, again, who has a terrible relationship with Ford, they really dislike each other. Roosevelt even comes out to Willow Run and does a automobile tour of Willow Run. They have to do it in a car, a Ford, of course. because it’s so vast, and they drive around together, and Ford apparently is sitting in the middle seat of the back of this Ford, squeezed between Franklin and Eleanor, both of whom he hates. And his son, Edsel, is sitting in the jump seat facing Ford, and Edsel reported that Ford was giving him the stink eye the whole time because he was so unhappy sitting between Franklin and Eleanor Roosevelt. But he helps the U.S, even though he was not a fan of Roosevelt, even though Hitler actually mentions him in Mein Kampf, the only American to be mentioned in Mein Kampf. Despite all these things, he really helps America build the armaments they need to fight World War II. And then, you have Lee Iacocca, who’s the second of three auto CEOs I talk about in the book, and Iacocca enters the story as a Republican, anti-regulation, kind of free market guy who works for Ford initially, and his first appearance in the book is in the Nixon White House, when he comes to argue against Ralph Nader-style regulations being imposed on the auto industry, and he actually is quite successful in getting the White House to push back against Department of Transportation’s efforts to impose these regulations. But then, over time, the auto industry goes from on top of the world to being less successful, in large part because, you mentioned unions, the labor contracts that were negotiated by Walter Reuther, who’s the head of the UAW, end up becoming crippling. to Detroit. They imposed these huge long-term costs. The Detroit auto manufacturers thought they were getting good deals because they limited the wage rises in the short term, but in the long term, there are all these pension benefits and health benefits. That ended up being crippling to making the price of American cars affordable. And at the same time, these regulations are being imposed by government and by the U.S. government, and it makes it more expensive to build cars. And so you see the rise of automakers, especially in Japan, that are really eating America’s lunch, and so Iacocca… First, now he’s head of Chrysler, he has to get a bailout from the U.S. government, which he does under Jimmy Carter, but then he also wants all these tariffs and limits placed on Japanese cars coming into the U.S, so he goes from this really kind of free-market Republican to a pro-interventionist Democrat as the interests of his company change. This reminds me of something that Elaine Chao, who was one of my first bosses in Washington, I worked for her when she was Secretary of Labor, she told me that you can never count on business to be in the foxhole with you. They’re not ideologically committed to the same things that we were as George W. Bush Republicans. They’re committed to the interests of their business, and they will abandon you if whatever position you’re taking is not in the interest of their business. I thought it was a really important lesson, and it was something that stuck in my head as I wrote this book.

Jon Hartley: It’s fascinating, I mean, the whole concept of regulatory capture, this is an idea advanced by the Chicago economist George Stigler in the 20th century, and, I think it’s an idea that really resonated a lot over time, and at some level, large companies have a big incentive to form these regulatory modes. Or, to capture some sort of subsidies in some way, and obviously, what’s pro-business in this sense is not necessarily pro-market or pro- the American people, or favorable to using taxpayer dollars wisely that is promoting, good outcomes for the broader population. I want to fast forward a little bit further here and really talk about the rise of tech. Obviously the tech lobby is now hugely powerful, in many ways, in both parties. And, I’m just curious about what… who are the… main figures that you talk about. I mean, obviously, Elon Musk looms very large right now, or has loomed very large in the second Trump administration, but I’m interested in what you have to say about the rise of the tech sector in general that’s really grown enormously since the 1990s, and Their interactions with presidents, which… Seemed to be increasingly more relevant, more important.

Tevi Troy: Yeah, so high-tech comes in two waves. There’s the 90s growth of high-tech, mostly Apple and Microsoft. And… For that era, I talk about Bill Gates. And Bill Gates was kind of like Rockefeller in that he creates this new industry, he doesn’t think government’s relevant to him. I have this great quote from him in the book where he says that The private sector is 3 times as fast as the government. And the high-tech sector is 3 times as fast as the regular private sector, which means we’re 9 times faster than government. Okay, great, you’re 9 times faster than government, but government’s also big. If they grab you by the ankle, they’re not letting go. And I think he failed to grasp that, and I think when the government under Bill Clinton goes after Microsoft in the 90s, that really hurt Microsoft. Obviously, now it’s a multi-trillion dollar company, and they’re doing fine, but At the time, it really did set them back and allow a lot of these competitors to emerge, and Gates is chastened by what happens, and I speculate in the book, and there’s some reason behind it, I don’t just make it up, that he leaves the CEO position of Microsoft in part because he’s unable to make peace with the government, and the new leadership that comes in after him is more accommodating to Washington and what Washington wants, and Gates tries to transform himself from this kind of avaricious, sharp-elbowed, incredibly competitive person to being the kind of avuncular philanthropist that we see him as today. But that’s not what his perception was in the 1990s. And I have all these great jokes, Microsoft jokes. In the book, in my appendix, I have an appendix about jokes told by and about CEOs, and… one of the jokes in Microsoft World was, and this is based on Gates’ sharp-elbowed and very competitive interests, is. Windows ain’t done till Lotus don’t run, which means that Windows, which is the Microsoft software platform, was designed in such a way that Lotus, the IBM spreadsheet program, wouldn’t run effectively on it. So they wanted to make the Windows platform the platform so that you would prefer to use Microsoft products on, rather than other companies’ products And so that was just one of many jokes about how Microsoft really was trying to keep out competitors, and it ended up not working out well for Microsoft, because the government came after them and took some real hits. And we also know that Gates learns this lesson, not just because he leaves the company and tries to remake his image, but when he meets a young Mark Zuckerberg, and Zuckerberg is really at the cutting edge of the second wave of high tech starting in the early 2000s. he tells this young Mark Zuckerberg, “get an office there now.” And by there, he means Washington, D.C. And Zuckerberg, as you well know, has built up a very powerful office in Washington, headed by my former White House colleague, Joel Kaplan, and it’s one of the biggest lobbying shops in Washington, and they’re involved in everything, and they see everything, and they’re spending a lot of money, and it’s in large part because of that lesson that Bill Gates imparted to Zuckerberg. Zuckerberg saw Gates as a model. They both grew up in upper-middle-class households, they both started coding at an early age, they both went to Harvard and dropped out to build their businesses, and when Gates gives him a lesson like that. Zuckerberg absorbs it and takes it in.

Jon Hartley: Well, that’s, really interesting, really fascinating, and just the whole enormous growth of the tech sector and its lobby. I feel like now you’ve got, the crypto lobby is very powerful, there’s many of these powerful groups. I also want to talk a little bit about the international components of some of these things. Since 2016, there’s obviously been sort of a shift in, thinking about trade, obviously, both the rise of Bernie Sanders. Democratic Socialist, sort of wing of the Democratic Party is very much opposed to sort of the free trade, Clintonite era. And similarly, President Trump, obviously, a big proponent of tariffs as well. I’m curious what, in your research and all the work that you’ve done on this. where does trade factor into some of these things, and any interesting sort of tidbits on sort of the international dynamics of some of these things? The U.S. has obviously has been the world’s largest economy for quite some time, even though it only has the world’s third largest population. I’m just interested in what you’ve learned about maybe trade or Or some of these other, sort of, relationships around some of these particular policy issues over time. I mean, trade, isn’t exactly a new issue either, in the sense that even in the Bush era, there were Bush 43 era, there were some tariffs. In the Reagan era, there were some tariffs on Japanese steel. From a foreign policy standpoint, trade mattered. There wasn’t very much trade with the Soviet Union, and there was sort of thought as, you had the First World, the free world, the second world, or the tiniest world, and then you had the Third World, which is African and elsewhere, and it’s where the whole phraseology of the Third World comes from. But I’m just interested in, sort of, your long-run, sort of, historical perspective how did the thinking around foreign relations, certainly in the Soviet era, impact thinking on trade then? And what were sort of the business people thinking then? Obviously selling to more markets. helps, business people in a lot of ways, but now the U.S. is home to all these massive multinational companies that are selling to many, many, many, many countries, and that’s part of why these companies are so big, today. But I’m just interested in your Reading of things. Any sort of international or other policy tidbits that you learned?

Tevi Troy: Yeah, it’s really interesting, and first, I may have to chide your chosen profession of economists, because they thought that it was just so obvious that free trade was correct, and I am a free trader, but they stopped making the argument. They just assumed, well, if you don’t believe free trade’s right, you’re an ignoramus, and they just stopped putting out additional research showing the benefits of free trade, to the point where the American people forgot that there are benefits that go to all when you have free trade, even though there are some people who might suffer. Overall, everybody is better off. And so that argument stopped being made. Then you have the business people, and I talked about Lee Iacocca, and you know, these people are happy to be free traders when it helps them get into foreign markets, but they don’t want to be free traders when it threatens their own businesses. So the business people really had no ideological commitment to free trade. And then you had The kind of globalist foreign policy types who thought, well. If other companies… if other countries are involved in trade with us, then they’re gonna reform and become democratic capitalists, and maybe we were, too arrogant after winning the Cold War, but this thought that if you just get economic liberalization to China, then it will become a democratic, free society, and that was just wrong. And I worked for Chris Cox in the 1990s. He was warning against that. He had a Democratic partner with him at the time, a relatively junior member named Nancy Pelosi. Both of them were warning about the dangers of integration with China, and maybe we should have listened a little more at that time. So I think you had failures in multiple places, and it used to be when I was growing up, that… or growing up in politics, that the Republicans were mostly for free trade, and they could get enough Democrats on board to pass free trade agreements. And now, it’s the Democrats are all against free trade, unless they want to criticize Trump. And the Republicans are split, but many of them will go along with Trump and back tariffs. I think if perhaps there’s a new leader in the Republican Party in the post-Trump era who is a free trader, I think the Republican congressman would probably go back in that direction, but For the most part, what you see is that whoever is the standard-bearer of the Republican Party gets to determine what the issues are, and what the issue mix is, and what the emphases are. When I was working for George W. Bush, he would tell me and others in the Oval Office, I’m against nativism, isolationism, and protectionism. That’s not something you hear from the current Republican administration. George Bush was head of the Republican Party not that long ago. 17 years ago, he was still head of the Republican Party, and these things change. So, I think these battles have to keep being won. I remember Nathan Glazer, the great neoconservative, was presented with some Marxist arguments once, and he said that, your questions are so old, I’ve forgotten the answers. But you can’t forget the answers. You have to keep working at it. You’ve got to win this every generation, over and over again. You can’t just assume that people are going to say, oh yeah, free markets and democratic capitalism are the way to go. You’ve got to keep winning that fight, and you’ve got to keep fighting that fight to win it.

Jon Hartley: Absolutely, and I was born on November 11, 1989, actually when the Berlin Wall, fell, and basically everyone born after doesn’t have any memory of the USSR and the sort of pernicious, effects of socialism that the people born prior to me remember. I’m just, wondering any final stories or thoughts from all your, fantastic experiences in Washington and your time working in the White House and Congress and elsewhere, all the research for all these books. Any other stories, or Or things about business people and presidents and Congress that you wanted to share?

Tevi Troy: Maybe I’ll share some life advice, because people often ask me for advice, especially young people … I know you have some younger listeners. Which is the importance of reading. You’ve just got to read in order to know things. People today, they assume they can learn everything from TikTok videos. There’s really a whole world out there, and just listening to your podcast, I get all these ideas about books to read, economists maybe who I had not thought of in a long time, and It’s really reading. The written word is the basis of our civilization. And our civilization, for a long time, has been moving in the right direction. I’m worried about some recent tendencies, but I mentioned Irving Kristol earlier, I believe in what Irving Kristol said, which is that he was short-term pessimistic, long-term optimistic. And so I’m long-term optimistic on America and democratic capitalism, and our values are better values, and they will win out in the end, but we may have some hard days ahead in getting there.

Jon Hartley: Well, it’s really amazing just talking to you, Tevi, about all your books and all your fantastic experience in Washington. It’s a real honor to have you on, and a real fascinating discussion, learning all these bits of history, between various titans and presidents. It’s really fascinating. “The Power and the Money,” a really great read. Thanks so much for coming on.

Tevi Troy: Thanks for having me, and thanks for doing your podcast.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Andrew, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Andrew Ross Sorkin, who is a co-host of CNBC’s Squawk Box and the founder and editor-at-large of Dealbook at the New York Times, where he’s also a columnist. Thanks so much for joining us, Andrew, and welcome to the Capitalism Freedom Podcast.

Andrew Ross Sorkin: Thanks for having me, I really appreciate it. This is gonna be fun.

Jon Hartley: Well, you know, I’ve been a huge fan of yours for a long time, and like many others, you know, watch Squawk Box very routinely. I just want to, you know, start by asking a simple question. I mean, how do you get up in the morning at, you know, in time, you know, to do a 6 a.m. show on the East Coast every single day? I mean, what time do you wake up? What time do you go to bed? I mean, are you going to bed?

Andrew Ross Sorkin: Oh, boy, oh boy. I try to be awake by, call it, 4:30am, 4:25am, 4:30am, which, by the way, is late in TV morning land. My colleague Becky Quick gets up, I believe. maybe even an hour earlier than I do at 3:30am, maybe. I live happily just, about 15 minutes, even the last 10 minutes, from the studio, so I can race there. I do the makeup like I’m an F1, driver, or doing NASCAR or something, as quickly as humanly possible. I try to go to sleep, I’d say… I want to be asleep by 9pm, or 9:30pm. That would be ideal, but I would probably say, you know, once or twice a week, I sort of push 10pm. If I go to sleep after 10pm, it’s not a good situation.

Jon Hartley: It’s amazing. I mean, it’s such discipline, you know, because I’m sure, you know, you have to, you know, leave dinner parties early, and.

Andrew Ross Sorkin: Oh, yeah, no, by the way, great excuse to leave a dinner party or cocktail party if you just say, I, you know, I always say, it’s a school night, guys, I gotta go. And, people seem… because they can see that you’re on TV the next day, people seem to think that’s socially an acceptable way to… To walk out. I do have to admit that definitely Sunday nights, and maybe sometimes during the week, I have to take melatonin to go to sleep at… That hour, meaning to, like, get to sleep, because sometimes I… I mean, I’m not… I don’t take any… anything else, but, sometimes it’s hard, especially if you get off the… you know, if you end up staying up till 10 or 11 o’clock on a Friday or Saturday night. I find Sunday night trying to get back in bed at the right time is a little… it’s like, you know, a little jet lag-ish.

Jon Hartley: That’s amazing and incredible discipline. One other related story that I’ve heard is that Hoover Senior Fellow Tom Sowell would, even without having a 6am TV show, would just routinely basically get up at a dinner party at, like, 9pm or 10pm, and would just go home. It could be in the middle of some great conversation, but he was very disciplined about going to bed early, every day. He’s written 40 books, and has this incredible, super influential career, you know, like yourself. So, maybe that’s the secret. We just all need to be going to bed, much earlier.

Andrew Ross Sorkin: I know a… I’m not gonna out him. I know a very famous CEO, chairman of a publicly traded company, who I think, literally, because I’ve been at meals and places where, like, 8pm… 8:15pm rolls around. And this guy just gets up out of his chair and walks out, and almost just doesn’t care. So maybe, you know.

Jon Hartley: Amazing. Maybe that’s the secret.

Andrew Ross Sorkin: I don’t think anything interesting happens late at night, but I know a lot of people, tell me that a lot of interesting things happen late at night, and clearly I’m sleeping, so what do I know?

Jon Hartley: Well, that’s… that’s too good. I want to get into your career a little bit. Growing up did you see yourself or imagine yourself becoming a journalist? Was there maybe a specific moment where you realized that that… that journalism was going to be the path for you, and particularly covering finance …

Andrew Ross Sorkin: So, absolutely not. Like, 1000% not. I had no interest in being a journalist. I find writing very hard. Like, even today, I still write books, I do write articles every day. I don’t play the computer keyboard like a piano. I sit there, and I’m hunting, and I’m pecking, and I’m in pain, and all the things. So, I never thought I’d be a writer, ever. And… I wanted to be in business. I thought of myself a bit as an entrepreneur, I still do, in some respects, but when I was 15 years old, I started a sports magazine. Not because I was interested in the journalistic aspect of it, per se. I was interested in sports, and I thought I… I thought there was an opportunity to sell a lot of advertising, actually, around the magazine at the time. And… I went off and, tried to turn the magazine into a national magazine. It ultimately actually failed by the time I was 18, but it gave me an opportunity to get my foot in the door as an intern, sort of a pseudo-intern, unofficial intern at the New York Times when I was in high school. And there was a woman there who was an editor who had no idea how old I was. I was in the building, I think I had my suit on, I think I was wearing a tie. She thought I was a college graduate, who, you know, was like a news clerk or something. She overheard me talking about this thing called the Internet in 1995, and she assigned me a story to write. And I went off, and I wrote the article, and the truth is, I thought I would… I thought it was, like, a one summer, never again situation, and then I just kept doing it. And I fell in love with it, because I… I do… I do love business. I always… I’ve been a… I really thought I’d ultimately, you know, go to business school after college, or something like that, or maybe law school. And I… but I always thought if you could follow the money, it explained everything. And I don’t say that cynically, I mean… but it explained not just business, it explained politics, it explained sports, it explained parts of the world of art, everything. And so. I just became enamored with it, and I’m also just fascinated by the characters, the people, and the motivations and incentives that people have, and why people do what they do. And that’s… Really has led so much of what’s turned out to be a career in journalism.

Jon Hartley: That’s amazing, and I guess the entrepreneurial mindset, I’m very much impressed by. I mean, you started Dealbook. When did that idea hit you that, you know, that there wasn’t good enough business coverage out there, and that you could do this?

Andrew Ross Sorkin: Well, so I’ll tell you what was going on. I was… so I was working at the New York Times, I had graduated from Cornell University, I had been at the London School of Economics my junior year, part of my junior year. And I had covered business for the New York Times based in London. So when I graduated, they sent me back to London. This is the top of the M&A boom. It was late 90s, everything was booming, it was unbelievable. I moved back to New York, this is now end of 2000, 2001. And I’m thinking, oh, this job should be a lot easier based in New York, because the New York Times is based in New York. And so all the bankers and lawyers and people are gonna read the Times. And a lot of them, I’d go around and meet different people in the business, and they’d say, Sorkin, you know, you seem like a nice kid, but… the, you know, we get the times at home, we read the front page, we read the sports page, and then I take the Wall Street Journal with me on the subway to work. dagger to the heart. So this was… and I’m thinking, oh goodness, how am I going to get in front of these people? Super important that we have, you know, super competitive coverage, and I actually thought a lot of our coverage was really competitive, they just weren’t seeing it. And so… I had this thought, well, what happens if we sort of just go straight to their inbox? And this was way before, you know, Politico and Playbook, or Axios, or Semaphore, all of the… I mean. This is before, frankly, blogs. You know, the idea of even linking to somebody else’s website, to another news organization’s website, was almost anathema at the time. So, but I thought, I’m spending an extraordinary amount of time running around the internet looking for stuff. Other people are doing the same. If I could put all in one place for people. You know, that would be a valuable service, and we could try to get some advertisers to advertise against it, and ultimately, hopefully, the audience would be, you know, a valuable one. And it was really built originally… I remember the Times, I think, told me they thought there was a, really an audience of only maybe 30,000 people for this product. That was… they didn’t use the phrase TAM, but maybe today you’d say TAM. And we had, I don’t know, within maybe 3 months, we had, like, 80,000 people, re… people would be emailing me, trying to get on the list. I remember used to get… CEOs would call me up… CEO secretaries would call me up and say, can you fax us, dealbook? You know, we don’t use email. And I… So, and and that’s how it began.

Jon Hartley: Wow. 25 years later. That’s amazing. You were so ahead of the curve with hitting inboxes every day, and multiple times every day. All before the rise of newsletters today. It’s amazing. It’s a great newsletter. I read it.

Andrew Ross Sorkin: Thank you. Our audience is much bigger now. I think we… a million-plus people read it every day, so it’s a lot different.

Jon Hartley: So, I guess then, from there, how did you also get into video journalism, when did you decide you wanted to do TV and in particular CNBC?

Andrew Ross Sorkin: Oh, so I… the truth was, I was writing lots of different articles, trying to break news of different mergers and deals, and there was a period of time where I was covering… actually, a lot of the deal folks got into trouble, so I was covering white-collar crime. And a lot of the articles I was writing, I would get calls from bookers at the different TV shows. They’d call me up and say, could you come talk about your article? I used to go, you know, I was covering the Martha Stewart trial, I’d go on the Today Show with, with Katie Couric and Matt Lauer back in the day, or on Charlie Rose, or one of these programs. and then onto CNBC, and I would, you know, come on as a… as a guest, expert, if you will, about a particular topic, deals, or what have you, and then in 2011, I was going on TV probably more… especially around the financial crisis. I had written this book, Too Big to Fail, and then in 2011, they were re-shifting a little bit around, what Squawk Box looked like, and what the show, Squawk on the Street looked like, and they were, Carl Quintanilla, who’s a great friend, who was one of the three hosts of Squawk Box, they were gonna move to Squawk on the Street to try to create some continuity between the two shows. And they called me up and they said, hey, would you want to host a TV show? And I said, are you crazy? I mean, I didn’t even know how to, you know, I still don’t really know very well how to read a teleprompter. But, that’s how it began. So I added that to my list of activities, and it’s been great in so many ways.

Jon Hartley: It’s amazing, and also, you know, Squawk Box is, you know, certainly the gold standard for just the guests that you have and the conversations that go on there. It’s really amazing, just over the years. I can remember just so many, you know. there’s too many guests to be able to remember, but, just so many, you know, key moments that, you know, key conversations that, that, that have happened, just in those, few hours in the morning. So, you know, now, like, I want to get into books, and so, like. You know, obviously 2008 was a hugely, formative event, I think, for everyone, who was around at that time, and certainly working on Wall Street, and I mean, you know, even just mom and pops, you know, on Main Street, hugely affected, you know, those with. those who lost their jobs, those, you know, who saw their 401Ks get devastated. What was the moment that told you that you were gonna write the definitive account of the 2008 financial crisis?

Andrew Ross Sorkin: Well, first of all, I never knew that I was going to write the definitive account of the financial crisis. you know, what happened was, I was working, as you might imagine, the weekend that the Lehman Brothers was filing for bankruptcy, and Bank of America was buying Merrill Lynch, and AIG was teetering, and I… worked that weekend every… you know, back then, by the way, everyone was in the office all the time, I mean, usually till midnight, and I remember that Sunday night, I worked the whole day like crazy, working the phones, writing like crazy. We ended up writing… I wrote the front-page article for the paper with, several of my colleagues. And I remember going home, Must have been 1, 2 in the morning. And I remember waking up my wife and telling her all of the things that had happened, because I couldn’t believe it. And I remember saying to her, it’s like a movie. I mean, I couldn’t… it was almost like the world felt like it was going to fall off its axis. I mean, I couldn’t even sort of contemplate what was happening. It was so… felt so momentous. And she looked at me, and she said, no, Andrew, it’s like a book. And, we ultimately got a movie out of it, too, but that’s really what led me to write the book. I’d been thinking of wanting to… I’d always wanted to try my hand at writing a book, but I’d never felt like I knew what the subject was that would really sort of captivate my own curiosity and interest and hold my interest for what I knew had to be a long period of time. Everybody I knew who ever wrote a book said. You gotta fall in love with the story or the characters, because otherwise, you know, you’re gonna be doing this for a year or two, or whatever it is. And then I spent the next year basically in a race, because a lot of other journalists were also writing books about this. So it wasn’t just, you know, I didn’t have my own lane, and I just… I worked flat out, for… for about a year, and then the book came out.

Jon Hartley: Right. Well, and I guess, you know, through your other roles in CNBC and New York Times, you know, you had access to people. I’m sure you were able to talk to people who others couldn’t.

Andrew Ross Sorkin: So, it’s funny, I was not actually… I wasn’t hosting on CNBC. I was going on CNBC a little bit. I didn’t know all of the main players before this began. I knew a lot of bankers and lawyers and people who were involved in it, but not everybody. And what I found, though, was that there was sort of an 80-20 rule to reporting. If I could get 80% of the way there, meaning if I could get enough people to tell me certain things, I could then go to other people who didn’t necessarily either know me or want to talk to me, or… and by the way, there were people who either didn’t want to talk to me, or for legal reasons, there was all sorts of, you know, civil cases taking place. There was, I think, anxiety about criminal cases at that time, if you recall. Oftentimes it was sort of learning about certain pieces of information, or sort of understanding a scene or a moment, and then being able to call somebody who maybe I didn’t know and say, look, I know you don’t want to talk to me, or I know we’ve never met. But here’s what I have, and so I just want you to understand where I am. And I often found that they were… I don’t know if I would say impressed enough by that, but some of them thought, okay, you know what, I should probably talk to this guy. you know, some of them did it for the right reasons. They really believed in the history, and they wanted it to rewrite. I know people who, frankly, did it for the wrong reasons. They won’t, you know, they wanted to spin or rewrite history, or they were trying to screw over somebody or the other. And then I think there was this other group that Probably did it, even if they didn’t want to, you know, spoke to me ultimately, even if they didn’t want to, in part because… They felt, you know, that they needed to. Given that so many other people were talking.

Jon Hartley: That’s, that’s amazing, and really, amazing, these narrative accounts, following people and what they say, those sorts of narrative nonfiction. I think it is just so great in the sense that, you know, it really, takes you there and almost makes you feel like you’re in the room for these huge events.

Andrew Ross Sorkin: I was gonna say, my favorite books, I don’t know about you, I always loved, you know, Barbarians at the Gate, you know, which was about the RJR Nabisco takeover in the 80s. Den of Thieves, to me, was one of the great business books that I always loved. I loved Liar’s Poker. I love those books.

Jon Hartley: When Genius Failed?

Andrew Ross Sorkin: When Genius Failed by Roger Lowenstein. You know, there were so many of these books that brought you in the room, that made you feel like you were there, and made you not just think about it in the sort of systemic, sort of, in fully economic terms, but in people terms, because to me, ultimately, it’s the people that make decisions that ultimately lead to some of these systems and economic cycles and things, so… That sort of was always my North Star.

Jon Hartley: Absolutely. And you wrote this first book in 2008 (Too Big To Fail). You’ve written a second book, 1929, and this takes, you know, readers back to, you know, the original, you know, massive financial collapse, where the stock market fell by about 90% from 1929 to 1932. In 2008, we saw the market sell off by almost 50%, you know, by going by the S&P 500. I’m just curious, you know, what made you want to return to that moment? You know, I’m sure you could write on all sorts of, you know, things happening now. I mean, AI, COVID, you know, lots of things that are happening that are very interesting. I’m just… I’m very impressed that, one, you know, you’ve written this great account of history, you know, it’s nearly 100 years ago, and it’s at the top of the New York Times bestseller list. I can’t remember a time where there’s been a great you know, history book that’s had some same power in the New York Times bestseller list. I think nowadays, you know, memoirs are very popular, self-help books are very popular, but, like, true, you know, history, sort of written well, it’s fantastic to see it doing well, but what made you want to write another book, in particular?

Andrew Ross Sorkin: Well, thank you. First of all, I had no idea whether it would do as well as it has, and it’s, you know, knock on wood, it’s been… it’s just extraordinary. But, maybe I need to thank my wife again. We went on vacation probably about a decade ago, and so many people had actually asked me you know, about 1929, comparing it to 2008, and after reading Too… after writing Too Big to Fail, they thought I would probably know a lot about 1929, and the truth is that I didn’t. And so, I mean, I, you know, I read the old, Galbraoth book, you know, years ago in college, I think. But I didn’t feel steeped in that period, and so I went on this vacation, and I brought all these books with me, and I downloaded books to my Kindle to try to read about this period. And there’s some extraordinary and very, very interesting books about this period, but I remember saying to my wife. kind of, I think, on the flight home. You know, for some reason, there’s not one of these kind of, like, Barbarians-at-the-gate version books. There’s not a too-big-to-fail version of 1929 that really makes you feel like you understand who these people are and what they’re actually saying to each other. A lot of them were written by economists, or sort of a different writing style back then. I thought, well, is there enough information? It may be that there’s not, you know, the detail, the sort of granular detail that you’d need to be able to, you know, capture a conversation. Where are you going to get the quotes? How are you gonna… how could you make a book like this? Could it even be possible? And I happened, maybe, about 6 months later, to be up at Harvard University. I was supposed to give a lecture, and I got there early, and I happened to walk into Baker Library. And I asked the archivist there if I could look at some of the boxes of Thomas Lamont’s papers. And Thomas Lamont was the fellow who effectively was running J.P. Morgan during this period. And… I’d asked for some of the boxes from 29, I think, in 30. And as I’m going through these papers, I realized that he was keeping these extraordinary diaries. His secretary would keep notes and sometimes even transcripts from these meetings and phone calls he was having with Hoover and Roosevelt, and it was… I thought to myself, oh my goodness, this is amazing. this is how you could actually craft a book like this. And I remember going back to the archivist, and I was explaining to her what I wanted to do, and she looked at me and she said. I don’t think you can do that. And I said, what do you mean? He said, well, there’s… you know, Thomas Lamont kept great… kept great records. Most of the other people probably didn’t, and there’s not one or two or three archives that you’re gonna just be able to go find to go do this. And I sort of took that as a personal challenge. And then spent the next… basically 8 years, finding… and she was right. I mean, there was… this has required, ultimately, dozens of archives, meeting family members of certain people, getting depositions, and… diaries and notes and letters from all sorts of very, you know, places that I never really imagined I’d have to go. And then I got very lucky. Which is I… I had been… I realized that the New York Federal Reserve Board had never released the board minutes from those meetings. For whatever reason, 100 years later. The current board minutes, by the way, they’re released on the website, you can go. 1929, the board minutes never existed. I mean, they never made them public.

Jon Hartley: like George Harrison, Ben Strong, those…

Andrew Ross Sorkin: Exactly, exactly. That period. And I thought… but also, so many of my main characters were on the board of the New York Fed.

Jon Hartley: So Tom…

Andrew Ross Sorkin: Thomas Lamont, Charles Mitchell.

Jon Hartley: Head of National City Bank at the time.

Andrew Ross Sorkin: who was head of the National City, which becomes Citigroup. He was really the, sort of. The leader of the largest bank in the country at that moment. And so I got the New York Fed to… Release these minutes to me. And once I had those minutes, and you don’t really necessarily, hopefully don’t actually feel them in the book, but it became a sort of treasure map for me in terms of where else to go to go figure out, you know, who they might have been talking to then, and sort of to put timestamps on things. And it really was extraordinary in terms of just what it did to the research process. In fact. interestingly, when they first sent me the minutes, they had actually had a lawyer go back and redact all sorts of information. I thought, what? Redact? What are you redacting? It’s 100 years later. So, anyway, that was sort of the research process, but ultimately, it was really about Reconstructing these scenes, you know, using these notes and letters and things, and oftentimes pictures, descriptions of rooms, architecture plans, all sorts of things like that.

Jon Hartley: That’s amazing. So, I’m just curious, like, what were some of the favorite stories or people that you learned about, you know, working on 1929 and writing it into the book?

Andrew Ross Sorkin: Oh, goodness, I am so enamored by one person in particular, John Raskob, who I think may be the Elon Musk of his era. John Raskob ran General Motors, in the early 1900s, and uniquely, and maybe importantly, really changed the culture around credit and debt in America. So in 19… so prior to basically 1919, it was sort of considered a moral sin to take on a loan. People didn’t even want to take on a mortgage. It was just something proper people did not do. And John Raskob, 1919, is thinking to himself, he’s running General Motors at the time, he thinks, how am I going to sell more cars? People… and I don’t… there’s not enough people who have enough money to buy cars from us. So, he says, we’re gonna loan them the money to buy the cars. This was the original, sort of, vendor financing customer financing kind of vehicle that GM starts. And it was that shift, and that thinking, actually, that changed everything, because then you had Sears Roebucks start to loan people money to buy appliances, and then you had Wall Street, Charlie Mitchell from National City, start to do the same, so that people could buy stock using margin. But then John Rascob becomes an extraordinarily, wealthy and successful investor. Then, like Elon, he gets involved in politics, ends up actually choosing the wrong candidate. He supported Al Smith. He… by the way, he… Al Smith was a Democrat. He was really a Republican. He sort of switches just to… just to get… get in with him to some degree. And then when he loses, he goes on a sort of secret campaign to really try to change the reputation, undermine the reputation of Hoover. I mean, I can’t imagine what John Raskob would have been like with Twitter. It would have been unbelievable. But then, John Raskob builds what is the equivalent of probably SpaceX back then. He builds the Empire State Building with his own money. No debt, interestingly enough.

Jon Hartley: Wow.

Andrew Ross Sorkin: At one point, he creates what might have been considered one of the first mutual funds in history, and then most uniquely, he writes an essay in the fall of 1929, long forgotten. Because he was considered a little bit of a philosopher-king. Everybody… journalists would listen to every word. They’d hang on every word of his… that he would talk about. He wrote this essay suggesting that America needed to have a 5-day work week instead of a 6-day work week. So back then, there was, we all worked on… most people worked on Saturdays, the stock market was open on Saturdays. But it wasn’t because he was a nice guy. His view was that he wanted to create a bigger consumer economy, and that if you had two weekend days, more people would buy cars, because they had time to go places, they’d buy different outfits, they would, you know, do things to their home, all sorts of things like that. And he suggested at the time. that all federal holidays should fall on a Monday, except for Christmas. So that you could get a 3-day weekend to create even more consumerism. And so I always thought that John Raskob was just this sort of strangely interesting, uniquely fascinating character that a lot of people don’t talk about today, but I think had a profound impact on America.

Jon Hartley: We should be thanking him for, 3-day weekends, I guess, at some level one. That’s amazing. And, yeah, I didn’t even realize that the stock market was open on Saturdays. I mean, it’s, yeah, it’s such a fascinating time. I want to, I guess. walk through a little bit, I guess, some of the narrative at the time, and obviously, my understanding, and having read the book. you know, a lot of these stock market, losses, you know, Black Monday, Black Tuesday, Black Thursday, you know, that’s all happening in October of, of, seems like all these financial crises always happen in the autumn for some reason. But, that was, really a key point, a huge breaking point. But I’m just curious, you know, sort of in the lead-up to all this, you know, we have You know, there was the panic of 1907, where, you know, the stock market crashed, and JP Morgan bailed out Wall Street, but then in, you know, we had the creation of the Federal Reserve in part in response to that, to sort of fill the role that JP Morgan had played as a lender of Last resort. But at some level, you know, the New York Fed, you know, they… I think they did use the discount window a bit during this time, but, you know, at some level, this, you know, we didn’t have deposit insurance, we didn’t have, you know, the whole concept of government stimulus wasn’t even coined or invented. It was really in response to the events of 1929 that John Maynard Keynes wrote treaties on money, I think, and then.

Andrew Ross Sorkin: Yes.

Jon Hartley: And then wrote, The General Theory much later in 1936. But, at some level, a lot of the sort of things that were. talking about today, you know, in terms of policy responses or, you know, deposit insurance didn’t exist at all, but were created sort of in response to that. So I’m just curious, like, you know, reading the book, I mean, what did you learn, sort of, about policy and how it’s been shaped by these events as well?

Andrew Ross Sorkin: Well, so, just for those folks who are listening to us, the book is not just about the crash in 1929, it really is the period of, call it the beginning of 1929 through 1933, which to me is the real sort of full arc of the story. The crash of 1929 was really just the first domino in a series of dominoes that ultimately were oftentimes political policy choices, that led to the Great Depression. It wasn’t preordained that what happened in 1929 had to lead to 25% unemployment by the time we got to 1932. It’s that we had a crash in October of 1929. By the way, by the end of 1929, by the end of the year, market was only down 17%. People forget that. It had gone down… basically, it was down 50% by November 13th, and then actually started to go up again. The problem was, so many people had bought on margin. People were going into these brokerages, putting down a dollar. They were getting loans for $10! It’s 10 to 1. And so, all of a sudden, the downdraft you know, just… there were so many margin calls, and people were losing their homes. And that was really the first domino, just the confidence that got sucked out of the system. But then it was the series of policy choices after that, everything from… the tariffs, Smoot-Hawley tariffs in 1930. I mean, go back and think about… Hoover wanted to win over America, you know, the election in 1928. He was trying to tell farmers, if you elect me, I’ll… you know, I’ll put these tariffs in place, and so he wanted to make good on his pledge, even though everybody was telling him in 1930, the economy’s, you know, teetering and this is a terrible idea. He does it anyway. you know, the Federal Reserve. basically doesn’t do anything. They sit on their hands for most of the time. At one point, Hoover’s trying to raise taxes, which is probably not a great idea during all of this. So there were a couple of things that were happening. And you’re right, there were no, you know, there were no insider trading laws, there was no SEC, there was no deposit insurance, there was a big debate about, you know, how do you backstop the banks when they started to… to tumble, you know, do you want to throw money at the problem? I think that’s one of the lessons we actually learned at Keynes, you know, that you have to throw money at the problem, but guess what? We had a gold standard back then, so it wasn’t like we could print money willy-nilly left and right, and so there was a big debate about that that was taking place during that period. By the way, there was no capital requirements. for the banks during any of this. I mean, the Bank Act 1940. So, there were so many pieces of the puzzle That really did come afterwards, and I think we learned from that. And for the most part, even though I know we’ve had other crises, including 2008, I think the lesson… there have been a lot of lessons, and I like to believe, you know, people always say, could we have another 1929? I always say, could we? We could, but by the way, 1929 doesn’t have to result in 1932.

Jon Hartley: Yeah. I mean, it’s fascinating, you know, when you’re talking about putting $1 down and taking $10 a lot of debt, I’m starting to think about zero-day options and some of the things that are going on now, and, you know.

Andrew Ross Sorkin: Well, there are… by the way, some of that does exist both in the options market, some in the crypto, some of the unregulated crypto space. I mean, there are… some of this does… does parallel.

Jon Hartley: yeah, I mean, it’s fascinating. I mean, in just, you know, in going through, I guess, some of these topics, you know, it’s like we had, you know, obviously, Carter Glass, Glass-Steagall, you know, that was another thing, you know, separation of investment banking, and, and commercial banking, I guess, you know, it wasn’t, you know, obviously, you know, Roosevelt coming in in 1932 sort of is a watershed moment. I’m just curious about the that election, in particular, like, what were the things that you sort of learned in that period about the policies and sort of the push, I guess, for, you know, what became the New Deal? Well… What were the things that…

Andrew Ross Sorkin: I think the biggest thing I learned… I had an impression, as I imagine many Americans do, that Hoover lost the election to Roosevelt because of the economy, that people believed that this depression was terrible, and they hated Hoover, and you’d blame Hoover for it. We always say that the electorate, you know, votes with their wallet. If you go back and look at the polling at the time. Two things were happening. One is the market was actually going up. It appeared to people, they thought the economy was getting better, during the election of 1928. I’m sorry, not of 1932. And, uniquely, the pivotal sort of voting issue at that moment was actually prohibition. And it appears that Hoover lost in large part because he supported prohibition more than anything else. So he loses, and… really, within a month of him losing, a lot of the banks start to get into a lot of trouble, and he sees that. And he is starting to think, okay, we really need to backstop these banks, somehow. And he talked about trying to use presidential powers to do that, but he thought that he couldn’t do that without the support of Roosevelt, who had now just won. And because he’s a lame duck, he’s thinking, you know, I can’t do this, and if I announce some plan to support the banks without Roosevelt also supporting the banks, or at least his… some kind of, You know, acceptance that this is the sort of long-term plan, people won’t buy it. And so Hoover secretly goes to Roosevelt and says, hey man, we gotta do this together, because otherwise we’re gonna have a problem. And Roosevelt basically says, talk to the hand. Like, I’m not taking this on, and I’m not saying yes to this, because he didn’t want to get tagged. If it didn’t work, he didn’t want to get tagged with it. He wanted to start afresh. And in fact, he kind of lied to Hoover, and said he would never do anything like that. And of course, two days later, after winning, he does exactly that, and closes down the banks, and then supports them, and everything else. So, you know. it was a very just sort of interesting moment to sort of watch the transition. The transition of presidential power in this particular case was very important, and actually. I oftentimes, in my mind, go back and think about Too Big to Fail, and I juxtapose the transition between Bush and Obama, actually, and TARP, and all the things that were taking place in the fall of 2008, and actually how well they worked together, and I think that’s one of the reasons that we got to the other side as quickly as we did.

Jon Hartley: Yeah, I remember… watching, I think it was some, financial crisis anniversary-type, event where they interviewed George W. Bush, and he, in reflecting on, you know, the events of the 2008 global financial crisis, basically said that going through his mind, and himself being a student of history. that he didn’t want to be a Herbert Hoover, that they didn’t want to sort of commit the same mistakes, and so, I, I think, and I think he, you know, he, he very much, you know, leaned on, making sure that they were, you know, with TARP, and, and, I mean, later, you know, the Obama administration passed the, the, The stimulus bill, and that, you know, they were very much on the same team. So, yeah, it’s amazing how, I think at some level, that moment there in 1932, 1933 really set the course for all these things that we have today. And obviously, there was a lot more that came after that, Social Security. I think 1935, and… and sort of the rest of the sort of New Deal. But it’s a fascinating period, and I guess I’m curious, like we also certainly when we were going through the global financial crisis, we heard a lot about. Glass-Steagall and separation of commercial banking, investment banking, I feel like, for a long time, one sort of thing that’s been pitched, and still pitched, I think, by, Senator Elizabeth Warren, when she’s on Squawk Box and elsewhere. Is that we need to bring back Glass-Steagall. But, you know, these were… Glass and Siegel were characters, and some of their characters in your book. I’m just curious, what, you know, what did you learn about them, and Congress and the role that they played in all this?

Andrew Ross Sorkin: Well, so one of the main reasons I actually wanted to write this book was because of Carter Glass, the character of Carter Glass, which I had never really spent extraordinary amounts of time trying to understand or examine. And it wasn’t until I really, went back and understood his own story. And by the way, he really was sort of the Elizabeth Warren of his time. And during much of the 20s, late 20s, he used to rail about this thing called Mitchellism, as in Charlie Mitchell, the guy who was running National City. He believed that by… Charlie Mitchell loaning all this money to folks, that it was going to cause, this speculative fervor, and it was going to upend America. And I… what I remember thinking was, oh goodness, now there’s a spine of a story, because there’s two characters that are sort of going at each other. Charlie Mitchell on one side, Carter Glass on the other, and this goes on for years. And of course. without giving it away, you know, Charlie Mitchell gets in all sorts of trouble, including, by the way, getting arrested at his own home, and Carter Glass ends up, obviously. creating the Glass-Steagall bill. But the other thing that was really a fascinating lesson to me is Elizabeth Warren and others today, you know, I think all point to Glass-Steagall as this sort of significant historical bill that’s pure, that was based on, really, this idea of, you know, breaking up the banks because they needed to be broken up, and because, you know, this was done for, you know, all the right reasons. But when you get behind the story, you realize, actually, that part of the bill wasn’t even written by Carter Glass. It was actually written, I mean, literally physically written, by a banker. who was trying to screw over another banker at JP Morgan. And that all of the sort of lobbying and things that go on in Washington today were going on then. You know, I used to have this sort of, you know, you think, oh, the good old days, there was no, you know, there was no money or influence back then. It was all the same. In fact, if you really read Glass-Steagall and understand how Glass-Steagall was created, part of it was created by the Rockefellers, effectively, to screw over JP Morgan. That’s what it was. By the way, with the… not just implicit, with the explicit help of Roosevelt.

Jon Hartley: Wow. That’s fascinating. Today, I feel like, you know, that something like that almost couldn’t happen in the sense that, like, you’ve got lobbies, there’s obviously, there is activity like that that goes on, but I feel like the… the lobbying from, you know, the banks is so much more organized. I mean, what was exactly the JP Morgan, or James Pierpont Morgan’s response to all this? The Rockefellers they had their own oil, dynasty, and they had Standard Oil, which… obviously got broken up later, too, or had already been broken up. I mean, what was the response from the House of J.P. Morgan at that point?

Andrew Ross Sorkin: Well, so what was happening was the son-in-law of the Rockefellers was running Chase, the bank Chase, which was owned by the Rockefellers. And they really wanted JP Morgan to get broken up. More than anything, so that they wouldn’t have the investment banking and the commercial banking piece together, because they thought that was competitively gonna hurt Chase. I mean, that’s what was going on. And so you had Aldrich, who was one of the Rockefellers, effectively, going to Roosevelt. And saying, we need to do this, and this is why. And he gave, you know, reasons that weren’t about screwing up J.P. Morgan, but that was behind the scenes what was really happening. And then you had Thomas Lamont, who would get meetings with Roosevelt, and he’d be in the Oval Office. Saying to Roosevelt, you know, we don’t need this, this is too much, you’re going too far, it’s gonna mess things up, and he was, you know, you could see both of them literally lobbying the president. I mean. It’s interesting, today, people think that it, that, you know, CEOs spending time in the Oval Office is unique under Trump. But not that different than what was happening, back in the 1930s.

Jon Hartley: Absolutely. And a lot of other investment banks, you know, Goldman Sachs was still nascent, maybe a commercial paper company. I remember, you know, when I was working at Goldman Sachs, you know, hearing a lot of these stories about Sidney Weinberg and his relationship with, with Roosevelt, but yeah, I mean, at the time, too, I’m sure just the… the power across industries was so different. You know, in the… as of 1950, it’s like, the richest metropolitan area in America was Detroit, and, you know, this was very much at the, you know, at this time, certainly in the 1930s, you know, the auto industry was just starting to take off, really, and… and I’m sure, you know, at some level, you know, the banks… weren’t maybe even as totally powerful as, you know, certain banks, you know, might not have been as powerful at the time, so you could imagine, you know, like an oil dynasty, and it’s also banking, you know, I mean, some banking interests might, you know, have some power and be able to, you know, fight against the banks. I mean, I mean, even now, I feel like, you know. Maybe around the time of the global financial crisis, you know, the banking lobby felt very strong, but just even today, and sort of 15 years later. I feel like the tech industry, they’re lobbying, you know, the crypto industry, you know, they’re lobbying. And you can see this right now, like, playing now with, like, you know, stablecoin regulation. Totally. Whether stablecoins can offer yield or not. You know, the banks obviously don’t want stablecoins to offer yield. Obviously, the stablecoins and the crypto industry does, and so, I mean, that’s going on right now in terms of, you know, the banking industry, like, wrote the line in the Genius Act, you know, preventing the, you know, stablecoins from offering any kind of yield at the, you know, for regulated stablecoins. But, I mean, these dynamics are super fascinating, to the least.

Andrew Ross Sorkin: It’s all repeating in its own way. That’s the fun part about life, is it… if it doesn’t repeat, it rhymes, so…

Jon Hartley: Absolutely. So, I’m just curious, like, in terms of, other, you know, particular players that you think were interesting, and, what, like, I guess, like. In terms of.

Andrew Ross Sorkin: Well, do you want to laugh? If you want to laugh, I’ll give you one of my favorites is a character named Evangeline Adams. Evangeline Adams was an astrologer based in New York. Who had an office in Carnegie Hall, and every banker, including J. Pierpont Morgan, was a client. And they would go visit her to figure out what she thought was gonna happen to the stock market. Literally. She had a newsletter back then with 100,000 subscribers. I mean, it was bigger than Dealbook, if you think about what it was at that time. And she… people would pay her $50 an hour, to come visit with her, like she was a psychiatrist, to tell you what was in the stars. And that’s what was happening. I mean, it was such a… she was such an extraordinary sort of character, I mean, a true character of characters during that period, and I couldn’t believe it. I remember somebody told me about her, and I sort of laughed. I thought, oh… That’s gotta be, like, a side… side thing. And then I find out that, like, all these real people are going to ask her what’s happening to the stock market. And then, by the way, they’re trading based on what she’s telling them!

Jon Hartley: That’s wild. My goodness. Crazy to the least. I mean. lots of people, you know, I guess are, you know, there’s lots of, all sorts of, crazy, you know, stock tips that, I think of over the years, you know, all these folks, but I mean, an astrologer, that’s their first. I guess I want to just, you know, maybe get into a little bit on sort of the bank run side of things, because, you know, in 2008, we hadn’t really seen bank runs in a long time in the U.S, and arguably, you know, 2008 was a run on money markets, and you know, those are not the kind of run that you’re used to seeing, but even just a few years ago with Silicon Valley Bank, you know, it was very much a run conducted by, you know, people withdrawing funds, you know, through their phone overnight. And so, you know, but what makes this, I think, you know, some of these photographs just so memorable is that, you know, you had the people waiting in line, to, you know, to get their money out of the bank, you know, for those that are watching, you know, What’s a Wonderful Life, which isn’t… I don’t think it’s a bank, I think it’s like an SNL or something like that. But, you know, that George Bailey kind of, you know, bank run. I’m just curious about some of the stories that you read, you know, about that. I mean, obviously, you know, if you’re a household, you know, a mom-and-pop household, and you can’t get money in the bank, it’s, you know, pretty frightening. But I’m just curious about, like, the psychology that that created at the time, you know, that the bank runs themselves. As well as, obviously, the massive, stock market decline. Like, I don’t think at that time you know, you didn’t have tons of savings, you know, in the way that you do in a robust way with 401Ks and IRAs and stuff like that, so I imagine that, like, the fraction of Americans at the time that actually owned stocks was probably somewhat, much smaller than it is today.

Andrew Ross Sorkin: Oh, it was meaningfully smaller, but in terms of the psychological impact, I think it was extraordinary, and, you know, I was struck… you know, you famously always see these… you were talking about the pictures of people, you know, around a bank, and of course, one of the first bank runs during this period was the United States the Bank of the United States, which, of course, unrelated to the government, but that was the name of the bank. It was in New York where it happened, and it happened because of a bad rumor, but I was struck… the famous pictures that we all see down at the New York Stock Exchange in 1929, you know, we see all these… Pictures of, like, thousands of people standing outside the exchange. I don’t think I ever really understood what they were doing there. until I worked on this book, which was… they’d all… you know, so many people, not just from New York, but from around the world, around the country, were coming down to the exchange during those… those terrible days to try to find out what was happening to their money. I mean, like, literally. This goes to… this is sort of a technology story, in a way, because… the stock market itself was so off in terms of, the prices that you’d see even on the big board compared to what was actually happening in reality. Sometimes they were 3, 4, 5, 7 hours behind, and it would be like, you know, a server today glitching out, basically. But back then, you know, so much trading volume was pouring through the system, and literally the system couldn’t keep up. And so, people were hearing rumors, parts of the city, part of the country. about where… what the stock prices were, they didn’t know, so they literally physically came there, like, to stand outside and try to talk to people, to find out, you know, could they sell their stocks, and what were they gonna do, and da-da-da. I mean, talk about a run on the bank. It was… it was actually the sort of ultimate run on the bank, and I’ve always thought that the technology issue, in part, actually It really helped the crisis, get, you know. so much worse, because people just almost decided, you know what, I’m just going to sell indiscriminately, I don’t care, because I just don’t really understand what’s even happening anymore. The other thing I was going to mention about the sort of psychological impact of all this is And I don’t say this in the book, my gran… because it’s not really a personal story in the book, but my grandfather was a messenger boy, with his brother down there, during this period of time, and he was, I think, his brother was a 16, he was, like, 11 or 12 years old. And he used to tell a story about watching somebody jump out of a window after all this happened. And as a result, my grandfather, he lived, till he was 91, 92 years old, he never bought one share of stock. His whole life. He bought bonds, bought real estate, never stock. And so I do think there was a whole… that whole period of time for a generation of people, they were worried about, you know, whether the money they were keeping at the bank was actually going to really be there when it was all over. They were worried about whether the stock market was rigged against them. By the way, and back in 1929, there was no insider trading rules. in some cases, it was being rigged against them. And so, there were so many, sort of. psychological impacts that I think impacted Americans that didn’t… wasn’t just about 1930 or 32 or 38, that lasted, you know, into the 50s, 60s, 70s, in my case, my grandfather, you know, into the 90s and aughts.

Jon Hartley: It’s amazing. I mean, some of these, you know, jobs, that exist, you know, that don’t exist anymore, you know, I met, there was this guy named Alfeld, who’s a private wealth advisor at Goldman Sachs for, I think, like, 75 years or something like that. He got his first job at Goldman in, like, the 30s. I think his first job was, like, he was, like, a wheelbarrow boy for the paper stock certificates, or, you know, something like that. It’s amazing, like, now, today, obviously, you know, we have instantaneous information, but, you know, back then, you know, it’s like. your stock was an actual stock certificate, and, you know, prices were delayed, and, you know, there was all these, you know, it took time to actually figure out what was going on. It just, you know, technologically, things were so different.

Andrew Ross Sorkin: And that’s, by the way, one reason why I like to believe that things are better today is actually the technology’s so much better, that you can actually look at it by the millisecond on the telephone. Now, at the same time, you could argue that a bad rumor can spread much more quickly, even more broadly, but I also would think that a bad rumor could be squashed that much more quickly, too, in terms of just the efficiency of it. But, you know. I remember when I was writing this book, there was a moment in 2021 where the whole GameStop phenomenon and AMC was happening, and I was thinking, oh my goodness, this also is like 1929. Certain ways. And people are, you know, talking up stocks, golden, you know, diamond hands, and this and that. And, no, I mean, that’s.

Jon Hartley: Yeah.

Andrew Ross Sorkin: Really, what was happening. And I wonder whether the technology… while the technology is better, I also wonder whether it could make a crisis better in the future, or worse in the future. And I just… I’m not sure I know the answer.

Jon Hartley: Yeah, I mean, I feel like at some level, you know, you’ve still got psychology, you know, behind these things. I don’t think, you know, it’s not like every trader is an algorithmic trader, and even the algorithms, you know, sometimes are not programmed appropriately to deal with, you know, certain sorts of stock market swings, and I think that’s… you know, part of what happened, you know, I don’t think they were expecting some sort of a short squeeze, you know, retail event to happen, and, you know, maybe the algorithms are now, you know, better equipped to deal with that, and why we haven’t seen, you know, much, too much since, the AMC and the GameStop pumps, but, But yeah, I mean, it’s, it’s super fascinating, to say the least, and you know, I think, you know, 1987 sort of gets, I guess, a similar sort of, people are still trying to figure out what exactly happened then, you know, when the stock market fell by 25% in a single day. And I know people, even to this day, I know who doesn’t want to manage money because they saw someone jump off a building in 1987. They didn’t want to invest because of that event in particular. The psychological effects of these things can have very long, long-lasting effects.

Andrew Ross Sorkin: One of the main characters of the book is a short seller, famous short seller. A lot of people on Wall Street know Jesse Livermore during that period, but Jesse Livermore was an emotional wreck of a guy. He was very successful in 1929, made a fortune, made about $100 million, but he was so, obsessed with trading that he, you know. He made the fortune, he lost the fortune, he made it back, he lost it, he ultimately, literally shoots himself in the head in 1940. And so, I think it can have… the emotional, psychological impact of this market is a real… a real thing for some people.

Jon Hartley: Yeah. You just came back to the, you know, policy, angle, and, you know, looking across both, you know, Too Big to Fail, 1929, I mean, is there a lesson or a set of lessons that you think policymakers and people in financial markets still haven’t, like, fully absorbed from these, these events?

Andrew Ross Sorkin: Well, I think they’ve absorbed some of them, and then we forget some of them. I think the biggest is that debt really is the match that lights the fire of every crisis, every systemic crisis. That just is… Is a truth, and we should just stipulate that at the top. I think people do forget that, also, every single time. It was margin debt in 1929, obviously it was subprime debt in 2008, and I think we always have to watch the debt levels. That, to me, is a huge, huge piece of it. The other thing is. You need transparency, you need disclosure. I think in a lot of the cases back in 1929, there was a lot of manipulation and other things going on. I think 2008, I think there was some manipulation going on, people didn’t understand exactly what was happening. And so, every time new financial products sort of come to the fore, we need to be careful about what the guardrails are around them. And then, the last thing I’d say is. And those things are basically to try to avoid a crash or crisis on the front end. I think the last thing we… and I think we have learned our lesson, Ben Bernanke, I think, demonstrated the lesson, because he did his PhD on this period of 1929, the Great Depression, is that when you have a crash, and you have a crisis, you need to throw money at the problem. Like, that is the lesson. That is the playbook, and I think We’ve shown that that playbook works. 2008, it worked. By the way, we did the same thing for a hot minute during the pandemic, and that worked as well. Having said that, the one piece of this that I… I worry about. Is we’ve told ourselves that when there’s a crash or a crisis, we throw money at the problem to create sort of a put on the market. And that works. But, you know, back in 1929, there was a budget surplus in America. Today, we’re living with, you know, $38 trillion of debt in America, and I’ve always thought there’d be some invisible line that we just can’t go over that would turn into a red line. And that actually could bring you back to a 1929 or 1932-like moment, where at some point, you know. Congress and the Fed and everybody else says, you know, we’re gonna spend another $5 trillion or $10 trillion, the things have gotten so bad, we need to deal with it, and we’ve done in the past, we’ll do it again. But at some point, the bond market raises their hand and says, we can’t do it this way anymore. And then you get into some kind of austerity trap, and then you really get in trouble. I don’t know, and that’s… that to me is… that to me is the big question.

Jon Hartley: Yeah, you know, I think 10 years ago, or 15 years ago Reinhart and Rogoff had this sort of 90% debt-to-GDP threshold that they found it, and, you know, it’s descriptive data, and, you know, there’s only so, you know, so much you can do with it, but, you know, the idea is that, you know, after, after you pass 90% of debt to GDP or so, that, you know, economic growth is usually much lower. And so, yeah, we’ll see, I mean, given that we’ve passed that threshold. But, you know, I think I’m in complete agreement with you that the lender of last resort powers, I think, you know, are super important. Much more so than, you know, I think quantitative easing, you know, I think it’s sort of had a mixed track record as a growth strategy, you know, think… think of, you know, Europe and Japan and the Bank of England, you know, they’ve all done as much or more QE as the U.S. as a fraction of GDP, and yet, you know, their GDP per capita’s been pretty flat, and their stock markets have been comparatively flat compared to the U.S, and I think, you know, the U.S. story is really that of, you know, technology, and it’s something that’s been very unique, and it’s been driving a lot of stock market returns in the past 15 years or so, but when it comes to those crises, you know, following, you know, Bagehot’s dictum, you know, lending freely at a penalty rate, you know, against good collateral, that that’s kind of the key, and I think that’s the lesson that, the key lesson that I think we’ve learned from, from 1929 that I think we’re now following in good stead. So I think maybe that’s one of the great lessons that policymakers seem to have absorbed here. You know, Andrew, it’s been a real honor to have you on and talking about your amazing career in journalism, New York Times and CNBC, and your two fantastic books. Definitely recommend to our listeners to read. both 1929 and Too Big to Fail. They truly are, I think, the two definitive accounts of the two, worst, you know, financial crises in American history. So it’s a real honor to have you on and talk to you about these books.

Andrew Ross Sorkin: It was a privilege to be with you, and what a great conversation. Thank you.

Jon Hartley: This is the Capitalism and Freedom, the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Luis, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Luis Garicano, who is a Spanish economist, a professor of public policy at the London School of Economics, and a former European Member of Parliament from Spain. Thank you so much, Louis, for joining us and coming on the podcast. It’s a real honor to have you on.

Luis Garicano: It’s my honor, I’m a big fan of the program, and… I’ve been… I’ve been even tweeting some episodes, and… I remember liking a lot the Levitt interview, which I learned a lot from.

Jon Hartley: Thank you so much for commenting on and talking about past episodes. Really, honored to have you on, and, and all your experience, you know. Both, in academia and in policy, it’s very rare to have someone who is both signing these things as an academic economist and also serving in government, working on regulation, particularly a place like Europe. Europe has certainly fallen behind and has had to deal with, overregulation, certainly in the past couple of decades. I think that’s shown up a lot in Europe’s growth. I want to start with your personal origins. You grew up in Spain, and you came to the University of Chicago for graduate school, where you studied under Sherwin Rosen. I mean, tell us about your formative years, you know, how you first got interested in economics, and how you went from Spain to Chicago?

Luis Garicano: So, I was, you know, I grew up in Spain when there was 22% unemployment was the norm when I was a kid, and that was a big economic crisis. So, like many people who study economics, I was fascinated by why could this happen, why couldn’t economy not generate employment, what was going on? We had many years of very, very high unemployment. Even now, we are highest unemployment in Europe. And so I studied economics. The teaching was kind of mediocre at the University of Valladolid, where I was studying, except for one professor who was great, and he inspired me to really enjoy it and really like it. He was doing, among others, a History of Economic Thought class, which I think now is missing. He taught from a Mark Blaug book, I don’t know if you know it, Jon. Economic Theory in Retrospect. It’s a book that explains you with supply and demand and current economics. It explains you the… what the theory of Ricardo means, how is the demand curve, how is the supply curve, what is Marx’s theory, and what assumptions. It was really interesting. And so I learned that, and I enjoyed it. I still went the policy side at the time. I went to the College of Europe in Bruges, which is the kind of the training school for European bureaucrats. I went to the commission to work as a, civil servant working on the… on Eurostat, on the Consumer Price Index, to harmonize all the price indexes for the Euro. I left pretty… bored and disappointed after that year in the statistical office. I was amused and saddened that that’s… that job is still going on. They haven’t still harmonized that bit, so I’m happy I left. Those 30 years could have been much less productive. And I had been left with this idea that I wanted to do economics, and I applied to Chicago. It was a… an application, that I’m not really proud of, in the sense that it was just, like, it was the year of the Euro, and I said I wanted to use monetary policy and central bank independence, which, I mean, it’s a big topic, but… but it was not a topic that really, I think was… I guess you could have given it the rules versus discretion treatment, but… It wasn’t really a research frontier topic, and… I was accepted, I was… I was a TA of… it was… it was the great years of Chicago, you… you remember those. those years where Chicago was… was… all the ideas were coming out of there. Chicago was getting lower prices every year. Lucas, Becker, Heckman, Hansen, Fogel, Miller, all those people. I didn’t get classes for Miller and Fogel, but everybody else was teaching in the core. Our core was amazing. I remember it was [Gary] Becker, [Sherwin] Rosen, [Jose] Scheinkman for the first, for the micro, for the macro, it was, like, Cochrane, [Robert] Lucas, [Lars] Hansen, for the econometrics, [Jim] Heckman, I mean… second year.

Jon Hartley: This was the real Chicago School prime, really right there in that period in the 90s. It’s amazing and to have been there then. I came only, maybe about 10, 15 years later, and, even then, it was still, there was quite a bit of that was still left. And I mean, Sherwin Rosen’s just amazing, and for those, I think, that aren’t familiar with the work of Sherwin Rosen, he’s done so much in the area of, organizational economics firms and, the whole concept of, spatial equilibria, the Rosen-Roback model is the canonical model of spatial equilibrium, we think about why is it that, you know, certain coastal housing prices are more expensive? You know, the Rosen-Roback model can sort of explain why, why housing’s so expensive in some places versus others, you know, places that have amenities or higher wages.

Luis Garicano: the superstar. the superstar model, I think, I think a lot about that, this 1981 paper. For listeners who don’t remember, basically argues that there are two key issues in superstar markets, like football, like opera, like music, which are… there’s joint consumption on the demand side, there’s a public good aspect, that everybody can listen to the Taylor Swift record, nobody needs to listen to the second. And there is imperfect substitution on the supply side. You cannot substitute 7 musicians for Taylor Swift, or 7 football players for Messi, or 10, or 25, it doesn’t matter. There is… the substitution doesn’t exist, and under those conditions, the rewards were very concentrated on the… on the very top. And so when you have elements in markets that give you super… like, give you this joint consumption possibility, like now with AI, where a big engineer can… can kind of change the AI that we all use, you get these superstar effects. I think it’s still very relevant. So Rosen was fantastic, Becker was fantastic. They were teaching me price theory, which I think is still… the most important thing I learned in economics. And one, contrary to what Levitt said in that interview, one essential input to to everything from macro to trade to, I mean, all this stuff, this restitution, all of these, derived demands, all of these things are what people actually care about in estimating in applied micro. Nobody’s using complex real analysis or real analysis for that. So, I would say, if you want to do applied work, Chicago was the right way to do… the right place to do it, and The presence of Becker and Rosen and Kevin Murphy, who were my main supervisors, was essential to my training. I loved learning from them, I loved being the TA of all three of them. I was the RA of forth Becker and Kevin Murphy. And that was the best training one person could dream. I can’t just not imagine a better team. Also, Candice Prendergast, who was a very good organizational economist, was in my committee.

Jon Hartley: That’s amazing. And you were hired at Chicago Booth as an assistant professor. You know, it’s really amazing, you know, all the work that you’ve done on, you know, firm dynamics. Organizational economics, you know, really the study of the firm, and, you know, firms are so important for economic growth, you know, innovation, and, you know, obviously, you know, regulation interacts with these things as well. I’m curious, a lot of your work has been done on certain topics. Some of these topics are somewhat theoretical, but, you know, this topic, this idea of knowledge, you know, of hierarchies, can you explain how, you know, exactly why that’s important, why it matters? I understand, you know, ideas are central to growth, but explain to me, sort of, how hierarchies and these things work.

Luis Garicano: Okay, I’ll be very happy to. So, so I think the idea, the general idea of organizational economics is that, macro, has always been, kind of, and growth has always been about K and L and A, aggregate capital, aggregate labor, aggregate productivity. There is always a sense that you add more stuff, it’s more output, end of the story, and you want to… you want to estimate, how much. Organizational economists try to open that black box in order to understand productivity, in order to understand economic growth, as you were saying. And my work has done that. My main contribution, I think, is my knowledge hierarchies work, which is in… was my dissertation work, is in a JPE paper in 2000, which is pretty highly cited, and, has maybe 1,800 Google Scholar sites by now, and, a couple of QJE pieces with Esteban Rossi-Hansberg, Pol Antras, and, and some other work with Esteban as well. Esteban Rossi-Hansburg, who is now in Chicago. And the basic idea is the following. Suppose you have a lot of workers, and they have different pieces of knowledge, and they have to communicate to each other. So, workers can use knowledge in production. And, in order to produce, you basically have to solve a problem. If you don’t know the solution, you have to ask somebody else. If you don’t know who to ask, so when matching problems and solutions is hard, a priority you only know that you don’t know, then I show that the optimal organization of the firm is what I call the knowledge hierarchy. A knowledge hierarchy is basically one where the knowledge is organized, where the routine problems are solved near the production floor. And the graph is kind of going up, and people ask for help or for directions from specialized problem solvers, or managers, who specialize in the exceptions. So, that way you minimize communication costs by asking about exceptional problems. And the higher-ups are specialized in more exceptional or equivalently more valuable problems, and you are basically, organizing the knowledge in that hierarchical way in order to solve the optimal utilization of knowledge. Now, we… I have done several, kind of, things to… to consider this idea. Harold Dempstitz used to talk about trading off the hierarchy trades of asking for directions versus training, right? So the knowledge… the worker could be superstar and know everything, and then doesn’t need directions, or you could have workers which are not great, but then you have the manager who knows and gives them directions, solves the harder problems. That’s the basic trade-off. And, we’ve applied it to thinking about inequality with sorting, so managers and workers sort with each other, you get a convex wage schedule with multiple layers, where that was the work with Esteban, where if you’re really smart. you’re solving… your knowledge is really very… you know a lot, and you… your knowledge has to be protected from dumb problems, so you get a longer hierarchy with more… better managers who can solve more things. Think of an RA, just to… to fix our ideas in the mind of an example that our listeners can understand. So think of… you have a TA, and you have a professor. The professor is very good, the TA should be very good, so that you can protect it from the dumb questions. Okay, there’s an integral, anybody can solve an integral, you shouldn’t go to the professor. If the students are not very good and the professor’s not very good, then maybe you don’t need a TA, and you can just directly ask. So… so basically, the knowledge organization, the positive sorting, the very good consultant should have good associates and good analysts, so that he’s specialized, he can really use his knowledge about the unusual problem. So. I had to work on inequality and on this heterogeneity in labor, and how communication… the key comparative statics is how communication and information technology changed this organization. Information technology allows the lower levels to solve more problems, so you get flatter firms. Eventually, if information technology was such that you could do everything yourself, you wouldn’t need to ask. So you wouldn’t have your one-person unicorn. And communication technology, which would be at centralizing. If you can easily communicate and don’t have the workers learn anything, just have them ask all the time. That’s cheap. So, so communication and information technology are very distinct, and work with John Van Reenan and Nick Bloom, also from Stanford, like you, and Rafaella Sadun from Harvard, we… we showed that, indeed, information and communication technology have different impacts on the organization of firms. I also had work with Esteban Rossi Hansberg on growth, showing that, firms can kind of deepen the hierarchy and go into… get the knowledge B, go deeper and deeper into the knowledge, so that they are kind of getting the more unusual problems about the structure that they are currently in. or explore, kind of go around searching, and then throw away their current hierarchy and move to a new knowledge field. Of course, in that case, all the structure they built is wasted. So we show, under what conditions firms will kind of get stuck in the old technology and not explore, because the hierarchy is so powerful, and we know so much about the current technology that, kind of, it would have to be amazing what we discover elsewhere in order to change, so… So the communication technology here can have the reversal of making you go too deep and not explore enough.

Jon Hartley: So, fascinating.

Luis Garicano: Yeah.

Jon Hartley: I mean, it just, yeah, I mean, the knowledge, innovation, ideas, human capital, you know, all these things are so essential for growth, and, you know, allowing them to flourish is, I think, a key part of that, and understanding how knowledge is organized, I think, is also really, really critical for understanding that. I want to talk just a little bit about, you know, you went back to Europe, you… you know, you became a member of the European Parliament. You know, I’m curious, you know, what motivated you, you know, as an academic economist, to run as a member of European Parliament? I mean, can you explain, you know, what you learned there during that time as an economist inside, you know, the belly of the beast of the European Commission, if you will?

Luis Garicano: Yeah, the start… the start of the… of the, career has to do with… the switch has to do with… after… after finishing at Chicago and being tenured at Booth, I… I stayed there. for 10 years. I decided to move to the London School of Economics, and the crisis came, and the 2008 financial crisis first. The Queen asked me about it, by the way. And I started a blog, Nades Gratis, with Tanos Santos.

Jon Hartley: The title of the blog is “nothing is free”. Right. It’s sort of, no such thing as free lunch kind of, title.

Luis Garicano: Exactly, no, no free lunch.

Jon Hartley: And this is in a Spanish newspaper.

Luis Garicano: Yeah, it was a Spanish blog. We did it on our own. We were on our own. Oh, very good. We got a website, and we started to put it. It was the time, the golden time of the blogs, and now it’s so open. It was with Tano Santos at Columbia, both co-authors and colleagues and close friends. I mean, at the very start, there were a few other people, but they all dropped out, and then eventually we left it, so other people have continued, of course. But that blog was very influential, because we were able to write about the crisis. I mean, that’s something I would tell economists to do, right? I mean, I think there’s always this advice people are given, like, oh, don’t do side projects. I think side projects are useful, because they… they… you learn stuff, you learn about the world, and you have impact. And sometimes, you know, you have more impact writing an interesting blog that gets the IMF to rethink how they’re thinking of your country than than writing a long paper that gets 35 sites, right? So, which doesn’t… is not so unusual. Papers do have that number of sites. So, we did that blog, I wrote a book about Spain, which was in the basis of the blog, which was Lidame Espana, it was a bestseller, I got involved in politics through that book. I was asked to write a program of this party. And then, they asked me to run for the European Parliament, and I said, yeah, sure, I’ll be running, because the Parliament is a good place for an economist, there’s more policy. I thought it was a good fit. And, I was ahead of the list, we got a lot of votes, we did very well, and I got to be vice president of the group. So it was very interesting. What did I learn?

Jon Hartley: The European Union, the promise of it is it’ll be a single market, free movement of capital, you know, both capital and labor, and goods, and so, you know, you have, I guess, free trade within the union. We’ll talk about the Euro in a little bit about the monetary union side of things, but I mean, the other side of it, too, is, you know, that, you know, the European Commission acts as a massive regulatory body as well. So, you know, Europe also, you know, regulates trade, I mean, outside of, I mean, to some degree, they act as their own trade bloc, but also.

Luis Garicano: Yeah.

Jon Hartley: They’re regulating things. They’re preventing, you know, tech firms from, you know, think GDPR, you know, the regulating technology, tech firms, all sorts of things. What did you learn? And you were there, sort of, at the, I think, the height of a lot of this, and I mean, it still goes on. I’m curious, what did you see?

Luis Garicano: So, I learned a lot. I mean, one thing, one general thing I learned is an economist is useful during a crisis. I mean, they don’t necessarily want to pay a lot of attention to our ideas, politicians, because they know they want to get votes, they want to see what pains votes. But during a crisis, with the Ukraine sanctions, and with the COVID, I felt I had a lot of ability to impact, because people needed ideas, so that was a good time to be an economist. Like, my friends who are neurosurgeons and when somebody has a brain tumor, and they all talk up to each other, and you’re like, oh no, guys, this… but they think it’s really cool that they are operating this thing. So, for an economist, the crisis is always interesting. And it’s an opportunity to contribute. So I learned that. On the question of over-regulation that you pose, I think it’s essential to our future. I learned that there was an ideology, ideas matter, and the ideology in Brussels had two elements that were very harmful. One is the process effect, the idea that we would be the regulators to the world, that we could just set up a set of rules, and we are such a big market, everybody will have to follow. I think that was a big mistake. I don’t think that’s… that’s correct. I think you set up a lot of rules, and then your firms are screwed, and then the rest of the world just looks at you like you are just crazy. And the second was the opposite of my blog title. Instead of no free lunch, all lunches are free. So I remember the first speech of the Commission President in Parliament, when we had to ratify her, and the first speech she gave was like. Well, the Green Deal for Jobs is the future of Europe, we’re going to fight the climate change, and there’s going to be so many more jobs because of this Green Deal. And it’s like, look, you can be… Against climate change, and wanting to do a good climate policy. What you cannot claim is that that’s just for free. I mean, that’s… like, you know, you’re going to raise the price of electricity and gasoline and gas, and you’re going to make it difficult for people to build, and also for other things, and that’s going to cost, and you have to tell people, and… And politics everywhere, but in Europe in particular, has become… had become, at the time, very much free lunch politics. So, ideas matter a lot, and this is how… this is how many of these things were discussed. People felt that The digital regulation… oh, that’s great, because we will be regulators to the world, and that has generated GDPR, which was before me. AI Act, which was happily after I left, so I’m not responsible for either of the two big mistakes of Europe. But a lot of the Green Deal legislation, I was there when it was proceeding. For example. the in 2035 without really a good cost-benefit analysis, without really any understanding of what that meant. I mean, if you do prices, at least people cannot adapt, and some people can continue if they don’t have chargers. This was a crazy volunteeristic policy that has just been reversed last week. So a lot of, kind of, regulation was based on this idea that, oh, we make a move to electrical, and then we will be richer, and better, and cleaner, and nothing will cost anything. And it’s like. you know, free lunch is not… is not a smart… is not a smart way to… to… to do… to do policy. So, on those years, I think there was a lot of… Voluntaristic policy making, I think, happened in the U.S. as well, under the Biden administration. And a lot of… unawareness of how we were really putting Europe in a pretty tricky situation. I mean, Europe, to be fair, has missed the… we were converging, until 1980 to the US, In 1980, we stopped converging. You could think it’s Ronald Reagan, you could think it’s something else. And since the mid-’80s, we have not… we have actually gone back relative to U.S. GDP per capita. And basically, it comes down to we missed the IT revolution. Europe was in the frontier of technology in 1980. Nuclear, trains, planes, cars, everything, fridges, all the, kind of, the technologies of the last industrial revolution that were… have been growing during the century. But when IT came, when radical change was needed, all our, kind of. filing costs, which discourage firms from… From, you know… making mistakes from, okay, you start in one direction, you make a mistake, you fire the people, you start in another direction. All that was very difficult to do in Europe, and that meant the two radical revolutions, innovation revolutions have happened. The IT and AI currently basically missed. And I think it has to do a lot with, with, With a regulatory… luxury regulation to make it equivalent to luxury beliefs, a phrase that we used in our blog. I have a blog with my song, Peter, that’s called Silicon Continent. We have 7,000 subscribers, a Substack, now.

Jon Hartley: It’s a great Silicon Continent, highly recommend it.

Luis Garicano: all these luxury rules. Luxury rules are rules that you set up just so rich, you know, everything has to be perfect or not exist.

Jon Hartley: So, I guess, like, you know, you mentioned, you know, there’s this idea, you know, the process of fact, I mean, it’s pretty unbelievable, I mean, the idea that I guess maybe the lack of humility that certain European regulators have with thinking that they’re setting the world standard, you know, with things like GDPR, regulating tech. And when I think at this point, a lot of this seems to be, you know, I think clearly you know, backfiring. You know, there is no real, you know, I’d say vibrant tech, you know, industry in Europe to speak of, at least compared to the US. But I guess, like, one, one, you know, reaction to that regulatory stage, I mean, you look at, like, for example, you know, Nigel Farage, and you look at, you know, the past 10 years of, you know, Brexit. I mean, part of the, complaint, that. you know, certain people in the UK, like Nigel Farage, had, you know, the UK party at that time, was that that there was this regulatory, behemoth that was, you know, the European Union, and that they wanted to leave, and hence they, you know, they went through with, you know, the Brexit vote, and, you know, by, you know, a certain slim majority, that the, Britain decided to leave. And, you know, part of that means, you know, they obviously have to. They leave the single market, and they have to reestablish you know, their trade ties and figure out what to do in terms of immigration and so forth between, you know, the UK and the EU. And then, you know, they never joined the Euro to begin with, so they didn’t have the monetary union sort of challenge. But, I mean, some people would say that, you know. the positive part of Brexit was that, you know, now the UK doesn’t have to deal with this thing called, you know, the European.

Luis Garicano: Let me make a broad intellectual point first, and then… and then address the Brexit and the over-regulation. The broad intellectual point, which is a very Stanford to Chicago point, is formed so well about the constraint. Yeah, the constraint versus the unconstrained where to think, and how you have to think of incentives, and constraints when you’re thinking about policy, and the Demsetz point at UCLA, but… but also Chicago in some sense. point about the nirvana fallacy. The nirvana fallacy is like, oh, well, you know, we have this problem, this other world is solved, like, the state will solve it. It’s like, okay, you want to think about constraints and incentives in state A, and you want to think of incentives and constraints in state B, the market and in state, in both of those cases, and in… In this excessive regulation, there is this sense, like, oh, we have a market failure, let’s intervene, and there is very little thinking about what will this intervention lead to? As to the Brexit specifically, and the… as the cause of… due to the over-regulation, I am in the UK right now, I’m in the London School of Economics, and It’s very depressing. I mean, look, Europe… has two problems. It has a problem of over-regulation, it has a problem of the single market, which is far from complete. the UK gave up the single market, which is a big thing to give up. in order to eliminate the over-regulation. They didn’t. They didn’t have the single market, and you will just not believe… I mean, there is this story everywhere in the press about 100 million dollar a pound spent in a bad tunnel. The HS2, the high-speed lane that was going to be… train that was going to be between London and Edinburgh. was budgeted for, like, $24 billion. It’s gone up to $110 billion, and it’s basically because it has become a tube, because it goes under everything, because there is some biodiversity this, or some biodiversity that, or there is some rule that… the UK is hobbled by rules more than ever. It’s unable to build electricity, nuclear plant, I don’t know how many… hundreds of millions they spent, billions, if I don’t remember wrong. We wrote a blog, About, my son wrote a blog, about how the sun in the Silicon continent, there was, like, an enormous number of millions, unseeming number of pounds, millions of pounds, to say each salmon. In the heat plant, in the nuclear plant that was built in the UK with enormous delay. So, the UK has been really wasting the chance. They’ve incurred the cost, which is given out the single market. In order to obtain that benefit potential, which is to become Singaporean themes, to be… to be a power in doing all this technology innovation Europe cannot do. And instead, they’ve just done nothing with it. I mean, they can’t build a tunnel, they cannot build the terminal in Heathrow, they can’t allow housing to be built in London. It’s very depressing, and I don’t think Nigel Farage will be any better, because he’s, basically not interested in policy, and because the voters he has are not interested in… you know, the problem of Europe Largely, is the problem of an aging electric. The Asian electric doesn’t really care. That young people don’t have housing. They don’t care that we’re not building stock, we’re not investing in the future, they want their pensions. They want their healthcare, and the politicians say whatever they want to say, but at the end of the day, look at France. They increased pensions, and they increased health spending, and they cut everything else. And increased taxes to pay for those health spending. So, at the end of the day, there’s a political economy problem that is affecting the UK as well.

Jon Hartley: Yeah, absolutely. So, you know, I guess I just want to talk a little bit about, you know, the monetary union side of things, because you also recently wrote a book titled Crisis Cycle: Challenges Evolution in the Future of the Euro with John Cochrane and Klaus Masuch. Obviously the Euro has had a very interesting, one, we had sort of the ascent of the Euro and the the late 90s and the formation, first the European exchange rate mechanism, then you had the formation of the Euro at the dawn of the millennium, and then, you know, we had this, you know, in the early 2010s, you had the European sovereign debt crisis. There were questions about whether or not Greece would exit the euro, or maybe other countries other indebted countries like Portugal, Italy, you know, I mentioned Greece, but also Spain, that, you know, potentially could exit, or that there would need to be some rethinking, to deal with the fact that you had this sort of, like, fiscal free riding thing that was sort of contingent, you know, on this big monetary union that the rest of the monetary union had to subsidize in some way. And then you had the sort of Draghi, whatever it takes moment, and that seemed to make things, sort of go away, at least the volatility in the markets disappear. And then, you know, sort of 10 years following that, you know, I mean, you also, you’ve got countries that are joining, wanting to join the Euro again. I mean, you had the Baltics in the mid-2010s that joined, or followed through with joining, the Euro. And even more recently, you’ve had, you know, countries like Croatia and others that are joining it. I’m just curious, I mean, what are the challenges with the Euro that remain, as you see? I mean, there is this, I guess, concept that, you know, you can you can’t have a monetary union without having a fiscal union. There’s pushes to have more Euro-wide debt, and it’s something that I think some European countries might not like, and I’m just curious what your thoughts are on…

Luis Garicano: agreed last Friday. Last Friday there was a meeting, where more European debt for Ukraine was decided to issue. So, the book, comes from a lot of the work, the policy work, I did over those years from Klaus. experience, on the, on the, on the European Central Bank. He was one of the earliest employees, and from John Cochrane. Who is a Hoover Fellow, as the audience will know. who is a fantastic microeconomist and a wonderful writer. And what we argued, is that, the European Central Bank, the institution of a monetary union without a fiscal union is perfectly feasible. We think that it was established, with clear rules and with clear-eyed view of what the… what the risks were. But, as the crisis, the different crisis came, we had four. one in a hundred years crisis, one after the other, the financial crisis, the Euro crisis, the pandemic and the war. In each one of these crises, the ECB jumped or destroyed some of the, some of the rules that were established there. Probably with good reason, probably it was necessary at the time, but at the same time. Not coming back to your rules afterwards. It’s true, after the first travel, the 2012, Mario Draghi demanded conditionality in order to do this, whatever it takes, and there was a clear conditionality for his outright military transactions. If he was going to rescue a country, that country had to be on a program. Like, think of an IMF program. But, and there was a banking union effort at that time, so some of the problems that were left unthought during the… the big thing… sorry, let me just go back to one important thing. The big thing that was left unsolved in the design was, okay, we have fiscal rules in order to have this common credit card, but people have their own income and their own expenses. How are we going to do it? We’re going to put fiscal rules. Okay, good. The problem is, what happens if people don’t follow the fiscal rules? Exactly. Oh, okay. And what happens if they’re bankrupt? they won’t be. We didn’t have an European IMF, didn’t have a banking rules that would allow banks and states to be separated, and banks not to direct states, or vice versa. We didn’t have a sovereign bankruptcy procedure. So when all these things started, it was all improvised the solution. And so, during 12, with draggy, and with the conditionality in the rescues, 13, 14 with the banking union, we were putting in place those institutions. But eventually. QE came, and the states discovered that, you know, money was cheap, debt was cheap, there was not much reason to put their house in order, neither fiscally nor in terms of growth. Not in terms, very importantly, of finishing these institutions, and they abandoned all these efforts to strengthen the Union, because you had the European Central Bank behind, why would you need a fiscal authority if the monetary authority can give you the money? For free? Why? Much better, much better. So, they were… they were kind of abandoning all these reform efforts. And our book is basically a plea to say, look. the fiscal… multi-union with a fiscal union can work, but you need to accept those constraints, and countries like France have basically jumped over those constraints. every time, since the start of the Euro, and as Junker said in a phrase that we have at the start of the book, he said, because it’s France. I mean, why don’t you sanction France? The president of the commission said, because it’s France. So France basically hasn’t had to fulfill these rules, and they don’t have the fiscal discipline from the Union, which is fine, then they should have the market discipline, but the market discipline disappears because the European Central Bank says we will intervene, and has a program, which is called TPI, the Transmission Protection Instrument, which is there to do that. So, in a way, you have neither one or the other, and the result is that You have a situation where the welfare states that keep growing, the pension demands which are politically imminent. are more powerful than the efforts to establish growth-enhancing reforms. I mean, Germany has decided, we don’t want a debt break because we’re in a defense trouble, and in fact, they take out the debt break. And what do they spend the money on? Welfare, because that’s, at the end, what the politics is. pushing. So, basically, what we say in the book is, look, we understand, dear ECB, why you did these things. We don’t think these are good presents to keep in place. These were exceptional moves. We need to go back to a system like the initial one, where those boundaries between monetary and fiscal policy are very clear. And, we’re… the institutions that require… are required for a banking union, including a bankruptcy sovereign Procedure. Illinois, you know, goes down, or Chicago goes down, then the U.S. government is not in the Federal Reserve. Nobody thinks the Federal Reserve will rescue Chicago or Illinois, and the examples sadly, are not totally unrealistic.

Jon Hartley: I guess part of it, too, is that, you know, I think a lot of these states are supposed to have balanced budget amendments, and that’s kind of, I guess, how… how a lot of that, you know, is supposed to work, but I mean, of course, there’s… you know, there’s exceptions to that, and it’s a very similar thing, I suppose, in the U.S. to Europe, as, you know, there’s fiscal rules that aren’t being followed by member states. Yeah, I mean, it’s fascinating. I mean, you know, I forget exactly what the school rules were, you know, something about 60% of GDP, I don’t know if this is the.

Luis Garicano: Deficent is 60%, deficit is 3%, that’s correct.

Jon Hartley: Wow. And then, you know, obviously, many countries just totally blew… blew past.

Luis Garicano: France, basically, my memory is that, just from memory, but I think only two times, only by mistake, fulfilled the deficit rule. Of course, the debt rule. France has been increasing the debt as a share of GDP every year since the start of the Euro, until today, every year.

Jon Hartley: Wow.

Luis Garicano: Maybe not in 2018, maybe that year or not, but…

Jon Hartley: I mean, do you see Europe as maybe being in a place where it’s sort of entering this period of fiscal dominance, where obviously you do have many very indebted countries, Germany’s starting to take on more debt, I mean, there’s… you know, a big shift in sort of developing their own, you know, defense now, and funding that, and Germany’s playing a role in funding that, you know, amidst the Russian invasion of Ukraine. But you see what’s happened in Japan, you know, Japan’s starting to raise interest rates now, their currency’s actually falling. And there’s some suggestions, I mean, Japan has even more debt, you know, compared to Europe, as a fraction of GDP, but now they’re running into these issues where they’re, you know, by even raising interest rates, that there’s expectations that there’ll be, you know, further problems, more, you know, higher interest costs on the debt, and, potentially future inflation problems, and that’ll just make, that makes the currency sell off. I don’t think Europe’s quite… reach that, but there are some concerns that there are these sort of issues that there’s now such a big fiscal, debt load that that…

Luis Garicano: I mean, the aggregate… the aggregate fiscal position is not… is not terrible. the problem is the distribution, right? You have… I mean, the problem of fiscal dominance doesn’t necessarily come from the… from the defense side. I don’t think that’s going to be our problem. I think it comes from the, again, from the pensioners, from the welfare states. I mean, I think we have very, very, very powerful… Welfare states, very aging electorates, with very low fertility. For the politicians, it’s always going to be preferred to satisfy this constituency. and the France, you know, both Bard de la and the popular… the Front Nationale, the right-wing populist and the left-wing populist, men and shown have noticed that the European Central Bank is there. And they both proposed that it should be, you know, France should be basically bailed out by Europe and by this European Central Bank, and that it should castle the debt, or… well, when they say we should talk to the ECB, and they should do things differently. Even Macron has recently said it. So the risk is more… dot… people play the Samsung game, like, if you don’t save me, I’m going to just take the temple down with me, and that is going to be hard for the ECB in front of countries like France or potentially Italy, although Italy is behaving well now. it’s going to be difficult to resist. So it’s more the welfare states, their growth. We… France doesn’t have scope for more taxing, and they are just lowering the pension age from 64 to 62. Imagine, after having done the effort to raise it. I don’t think… let’s imagine the alternative. France has the French franc. Can anyone imagine that they would be lowering the retirement to 62? I mean, it would be a big crisis, the franc would be falling, people, the markets would be scared, but they are in the Euro, and they are protected by the whole… by the European Central Bank, and by the whole… and so they can kind of hide their trouble. And, of course, If it starts to get bad, like in 2010, 11, 12, for someone who’s sold in 33 countries at the time, if it starts getting back to France. what is the ECB going to do? Is it going to let, you know, France fall? Are we going to go see a bankruptcy? Are we going to see the politicians really be serious and do a pension reform? I mean… All those things are very, very uncertain. So, in what sense, you’re protected against fiscal dominance because you have a board that has to vote, and the majority of the states are not profite, and the average debt is not bad, but on the other hand. you have this risk of gaming, of some member states kind of trying to figure out how committed is really the ACB to price stability, and the price stability and the ACB might have to choose between price stability, and then in some countries fall, and have some default. Or, fiscal dominance, and letting the price, the price objective, inflation objective call, call, call, Out of control, so… I think that the design still needs the elements that John and Klaus and me are getting. You need to make sure that the countries know that if they play games, they’re going to go in bankruptcy, and nobody’s going to worry. The banks are not going to fall when the country falls, and the country’s going to have to restructure their debt, and that’s not a big deal, like a big corporation, or like, you know, at least they need to know it, and then they won’t do these things. Right now, we’re in a bit of a situation where we don’t have the Commission enforcing the rules, the fiscal rules you were talking about, and we don’t have the market enforcing the rules, and that’s a bit scary.

Jon Hartley: Absolutely. I want to talk a little bit more about innovation, and I guess, you know, the lack thereof in Europe, getting back to a little bit more about regulation. You recently wrote a document, it’s titled, The Constitution of Innovation, with Bengt Holmstrom, a Nobel Prize winner, and Nicholas Petit. Can you tell us a little bit more about what you think the key ingredients for innovation are, and what’s holding it back, particularly in places like Europe?

Luis Garicano: Yes, so it’s… the title of our… of our document is after The Constitution of Liberty of Hayek. And, we are kind of echoing this way of thinking about, about, about that. We are looking into why is Europe kind of to 1980 behind. We think that The single market and the lack of innovation are essential… the single market and the excessive regulation are essential that Europe is doing luxury rules, is setting up all sorts of rules, that the Brussels effect, this idea that Europe is the regulator to the world, is insane, that costs… there’s no free lunch, that we have to understand costs, and that Europe should put prosperity as their main and only guide at the European Union. We should drop all the other things that Europe has been trying to do, focus on the single market. focus on letting firms scale up, eliminating regulations, and enforcing the single market. We inspire ourselves a lot from the U.S. Interstate Commerce Clause. We say, like, you shouldn’t… I mean, basically, mutual recognition in every case, so… If you can sell in one country, you should be able to sell in all the others. There shouldn’t need… be a need, in other words, for harmonization legislation, which is always a mess, and always kind of, at the end of the day. harmonizes nothing, because then each country implements the rules in different ways. Instead, we should just let the countries have their rules, compete, and everybody can sell products everywhere else. We talk about a federal commercial court, where firms that are not allowed to sell from one country into the next should be able to get a ruling in English in 180 days, and not have to go to the Commission, which never enforces. Or to a local court which don’t know European rules. So it’s really about getting a true single market and eliminating regulation. And instead of, like, other reports that I’ve been talking about. This, but having talked about what are the constitutional aspects of this. we proposed this set of reforms along the lines of what I was telling you. that actually will result in Europe working in a different way and producing. a completely different regulatory outcome. So, we believe that Europe is a good idea. We also, like Klaus and John, me, believe that the Euro is a good idea, but we believe that we are kind of badly, abandoning our initial purpose, which is, in the case of the Euro, low inflation, full stop. And in the case of the stable currency, and in the case of of, of this… of the European Union. It’s a single market that allows firms to compete and to scale every one year.

Jon Hartley: Well, I want to, just, I guess, my last question here, I’m curious, about your thoughts on the current state of Spain. The Spanish Prime Minister Sanchez, a Socialist Prime Minister, has been in since 2018. I’d say, one of the most pivotal and controversial politicians, in Spain, probably since Franco, and I’m just curious, in terms of, a lot of, his, the changes that he’s tried to put in place. I’m just curious, what do you think about, the trajectory of Spain in the past 10 years, 10-15 years? Obviously, there’s a lot of dynamics between, you know, Catalonia and, you know, certain regions, and… and my understanding is that, you know, the, essentially, to, continue to stay in power, Sanchez and the Socialists have, in part, allied themselves with the Catalonians; independence has been something that certain sections of Catalonians obviously want; either independence or autonomy. I’m just curious, what’s your take on all of this and all these changes?

Luis Garicano: No, I think the trajectory of Spain is extremely worrying. The markets look at our growth, and they say it’s great, but the reason it’s great is, we’re getting 500,000 immigrants per year. That’s, like, if the U.S. was getting over 3 million. That would be, that would be a problem for the U.S. It was a big crisis when we piping the U.S. with 1 million. So we’re getting extensive growth. We are not getting any increase in per capita income since basically 2008. All the GDP per capita that increased has gone to higher pensions, so the pensions have increased their average earnings, but the people between 18 and 65 have not. So, it’s been a… since 2008, Spain was converging to Europe until 2008, but since 2008, we’re basically stagnating over… The government of Sanchez has been extremely negative for Spain. Yes, he allied with the separatists in the Basque country and in Catalonia. In both places, he even allied with the supporters of the terrorist groups who’d never repented. get allied with the people who did a coup d’etat, the tie against Spain, tried to overthrow the Constitution. So… but most importantly, and also, of course, he allies with the Communist Party and the extreme left. He has basically, now… And it’s governing under a huge set of corruption scandals. Two number twos, his personal choices to run the party while he was in government. Are in jail, or have been in jail, and are probably going to spend a huge amount of time in jail, because they’ve been… basically scandals related to Venezuela and to construction. There’s been a big set of connections with Venezuela that we will find out. If Maduro goes, a lot of people in Spain are going to be panicking. Because the paperwork, the paper that will come out, will… will be… will be very incriminating. So there’s a big set of corruption scandals. He’s destroyed institutions, taken over the… public, the telephone company, which was privatized in the 90s, is put under state control. The main defense company that was in telecom… and intelligence… no, sorry, the first… the main… defense and technology company, which is Indra, has been put under his direct control. He puts socialist apparatchiks everywhere. He’s, destroyed, basically, the independence of all the regulators. So basically he’s trying of the Denmark versus Venezuela dilemma that I had in my El dilema de España, the book I wrote in 2014, and that… served as the inspiration for the program of the party that I was with. He… Ciudadanos, that I run for. He basically has chosen the road of Venezuela. He wants to turn Spain into some sort of banana republic. Happily. I think his time is over, part thanks to these corruption scandals. So, I’ve been very sad with Spain. I thought… the socialist part in Spain, traditionally, has been… pretty market-oriented and pretty sensible. During the 80s, they had a set of pretty good I mean, they were socialists, but they were, social democratic and non-European way, and they were not necessarily, there were not many of them, most of them were not corrupt, and so on. But this new socialist party has proven, like, to be another thing basically voted out by the party. He came back with support from the grassroots and basically eliminated everybody on the party who was sensible in any way, and has governed with… with a very… extremist and not clean, clique of people.

Jon Hartley: Well, hoping that, you know, Spain turns the corner and is able to recover from this decade of socialist rule. I really want to thank you, for coming on, Luis. It’s amazing hearing your perspective and your experiences, working not only as an academic economist, but also, your time in Brussels, as a member of European Parliament. I’m sure your students now at LSE really benefit from hearing from someone who’s, not just someone who’s doing research, but someone who’s actually, worked in policy, ran and seen a lot and done a lot. It’s so important, I think understanding how Brussels works. Understanding the European regulatory state is so critical if it’s going to be the case that innovation and growth are going to be revived in Europe in some way. So, really, thank you so much, Luis, for all you’re doing, and thank you so much for coming on. This has been a real honor to talk to you.

Luis Garicano: Thank you, my pleasure.

Jon Hartley: This is the Capitalism and Freedom of the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Matteo, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Matteo Maggiori, who is the Moghadam Family Professor of Finance at the Stanford Graduate School of Business, and is a Senior Fellow at the Hoover Institution. Thanks for joining us, Matteo.

Matteo Maggiori: Thank you for having me, Jon, it’s great to be here.

Jon Hartley: Well, it’s really an honor to have you on. I think you’re one of the leading international economists in the world, and really excited to have you on the podcast. We’ve known each other a long time, and I think the work that you’re doing is really fascinating on all the big issues in international finance: international hegemons and the rise of China, exchange rates, capital flows. All topics that I think are so interesting to people that are global macro practitioners on Wall Street, or are economists in academia. I want to first talk about your personal origins. How did you originally get interested in economics growing up in Italy, working at JP Morgan in London, going to do a PhD at Berkeley? Tell us about your personal origins and how you got into international finance and economics.

Matteo Maggiori: Oh my, that’s a long story, but I guess I’ll try to give you the quick version.

And part of my interest, which is common, for example, with economists, also from Latin America, was the big crisis of the 90s. So, Italy underwent several economic crises that had to do with the exchange rate system when I was growing up.

And that seemed such a huge topic. It affected everybody’s life. It was clearly, like, on TV a lot. It was something that people would discuss at dinner. And I sort of felt, well, this is interesting. It seems like a big deal, and potentially quite interesting. And my grandfather, who was not an economist, was very interested in financial issues, and sort of sat there explaining me the basics, and that sort of stuck with me. But I didn’t know that you could actually do the job of a researcher. You could make a living doing this. So I went to college, I did study economics, but I interpreted career research to be totally out of the question. I thought the professors were people that would teach, and then would have a private sector job, or some one of the liberal professions. So it was not really it was really… I was graduating, and an economist called Lucio Sarno came to visit.

And told me…

Jon Hartley: Which school was that?

Matteo Maggiori: Yeah, I was at LUISS, which is an undergraduate university in Rome, and it’s a good university, but it at least back at the time, was much more teaching-focused. Today, they’re doing a lot more, and they have a lot more research.

But I didn’t come from a family background where research and being a university professor was something that people could explain to me.

Jon Hartley: Did you grow up in Rome, or…

Matteo Maggiori: I grew up in Rome, so I was born and I grew up in Rome. I then went to do an exchange in London through the Erasmus program.

But I really didn’t think that I was gonna pursue this career. I thought best case, I was gonna be a banker at JP Morgan, or something like that. And then Lucio, who’s now a close friend, is a professor at Cambridge University in the UK. He came to give a seminar.

And, we met, they told him that I had finished all my exams very fast, and that I didn’t know what to do, and he explained to me that you could actually pursue a career, like the one that I ended up doing, which was a big change for me. So I ended up doing a master with him, actually, in the UK, then because UK masters are only one year, you really cannot get the letters for PhD by the time you want to apply in the fall, because you just started. And so I ended up doing a year at JP Morgan. Well, eventually it ended up being two, but at the beginning, I thought it was going to be just one year, trading currencies and interest rates.

But by that time, I was pretty sure I wanted to go and do a doctorate. But I was sort of waiting, and it was such an interesting experience, actually. It was wonderful, but at the time, I didn’t know. And that’s when I decided to apply to grad school, and then I came to the U.S. I came to Berkeley, because it was very strong in international. Maurice Obstfeld was there, Pierre-Olivier Gourinchas was there, Barry Eichengreen was there, it was just like an incredible… well, actually, Rich Lyons at the time, was also more involved in research, and he became a university administrator, and is now the chancellor of the university.

It was just a great environment to do international. But I’m one of those people that stumbled onto this career. I think the conditional probability of being born in Rome, and from the background I was coming from, that I was going to be a professor at Stanford was pretty close to zero.

Jon Hartley: That’s fascinating.

I guess growing up in Europe this is still, I guess, prior to the formation of the euro, was it things like the European Exchange Rate Mechanism and the sort of early stages of the euro that was, part of your interest in…

Matteo Maggiori: Yeah, the ERM crisis of the 90s were a big deal for me. You know, those happened when I was really very young, I didn’t quite understand what was going on, but it was such a huge economic event. That’s when I first got sort of interested in these issues.

Then, of course, for a while, I wanted to be a marine biologist or something else, like all kids. But eventually, when it came close to university, I would say that that experience of those crises was probably a big driver of my decision to get into economics.

Jon Hartley: That’s fascinating. You had the whole Soros and the Bank of England. It’s fascinating, I guess, how influential that moment has been.

You know, you’ve had an amazing career at Harvard and now Stanford, and really want to talk to you about a lot of your research, because I think people really anyone who’s interested in international affairs or international economics, I think is very much interested in these issues, and I want to just start by talking a little bit about China. It’s one international topic that’s attracted a lot of interest in recent decades with the rise of its economy, since the Deng Xiaoping era liberalizing its economy, growing into being a potential hegemon, competing with the U.S., its growing military might and so forth. You’ve written a really great paper on China, it’s titled, Internationalizing Like China. Could you explain what we’ve really learned in the data about how far along China’s come in your mind in terms of achieving or seeking to achieve hegemon status?

I remember when I was working at Goldman, it was a big deal that China was increasingly entering big benchmark indices, whether they’re equity or bond indices. I’m just curious, one, like, what are the facts as they’re evolving? And could a multipolar world led by the U.S. and China work if it were to come into existence, and what might that look like if it were to happen?

Matteo Maggiori: Yeah, these are fantastic questions.

We first got interested in China opening up the capital markets, because we were seeing more and more foreign mutual funds holding domestic assets, domestic bonds in China. And right now, the situation is very peculiar, I would say. We have this gigantic bond market domestically in China. It’s, you know, depending on how you count the capitalization, it’s the second, the third largest bond market in the world, that for many years was totally shut off from international capital markets. It was actually surprisingly difficult, if you were a foreign investor, to hold these bonds onshore.

Over time, China has gradually opened up this market. So the paper that you referenced with Jesse Schreger and Chris Clayton, was an attempt to think about this opening up process. They clearly started originally with programs that were almost bespoke. You have to apply, you have to be a qualified investor, there was a holding period. You know, you would think of it as almost testing the waters for China, getting familiar with what a foreign investor participating in their domestic market would look like.

And then it progressively opened up more and more. So the big watershed moment was in 2017. They instituted a program called the Bond Connect that allows foreign investors through Hong Kong to enter the domestic market of China, the bond market, hold the assets, and get out potentially quite quickly. And this was a much faster application process, much lighter requirements. And, correspondingly, you saw a big, sort of, inflow coming from foreign private investors.

The investors that we normally associate as being a little flightier, like the mutual funds or a hedge fund, not the very long-term passive investors or the official creditors, like, you know, foreign central banks, foreign sovereign wealth funds. So we started thinking about this process.

And we also wanted a model to think about if you’re a new entrant like China, you might have many of the characteristics that are associated with a potential reserve currency down the line. You’re a large country, you have a deep market, you have a lot of fiscal capacity, you’re militarily powerful, many of the things that we normally associate with a possible contender China has.

But currently, you have a very low reputation. You’re a new borrower on the block, nobody knows how you’re gonna behave, everybody might be worried that if too much capital comes in, in the next crisis, you might lock the gates, for example. You might not let them get the capital out.

And so we started thinking about how you would slowly build the reputation towards competing with the U.S., and it’s really like a trial by fire. You sort of start with, you let in very, very few investors. A crisis will eventually happen, they will get scared about you, they’ll try to pull out. If you don’t do anything, if you don’t impair the process and suffer through the crisis, when eventually it passes, they would have learned that you might be the good type, and they will bring in more capital. And you sort of keep going, but one of the things that this process shows you is most countries give up somewhere along the way. You have to suffer through a lot of crises to build up the reputation for being a country like the U.S., and most countries can’t take that pain, and give up somewhere along the way, and get stuck with a relatively bad reputation.

And then we started thinking about other issues, which I’m happy to touch on, which are why would China want to do this? In particular, what does it… does it impact the current account? And I really ended up thinking of it as they’re trying to generate two-way flows. They’re trying to have the foreigners potentially come into their domestic market. But they don’t necessarily want to move the trade balance or the current account, so what do you do? You let some of the locals take capital abroad. So the net doesn’t have to change, at least not mechanically. And you sort of… you’re building up gross flows.

And I think it’s probably for two motives. One is what we just described. You’re trying to slowly build a reputation on global markets as a potentially investable asset, and eventually as a very safe one. The other one, which is probably a more immediate concern, is if you wanted to generate a financial infrastructure that is separate from the one that the U.S. or the West controls, you need liquidity. You know, not all payments net immediately, not everything has a counterparty, so you need a liquid store of value. And the domestic bond market of China is really the only one with a size big enough to do it. But to do that, you need to progressively relax the capital controls. And I think that that’s probably a big motive in their mind right now, particularly given all of the financial sanctions.

Jon Hartley: So… have they largely just been focusing on, I guess, stocks and bonds? Like, I remember the China A-share, H-share difference, historically, Hong Kong, at some level, has sort of been this intermediary to attract capital into mainland China, and they’ll have H-shares in Hong Kong, and… or they’ll list some Chinese companies there. But I’m curious, like, on the real estate side, my sense is that things are still pretty closed, in the sense that I couldn’t buy a house in China, for example, if I wanted to, mainland China. Could I own a house?

Matteo Maggiori: Yes, there are, you know, across asset classes, from real estate to FDI to bonds and equities, the restrictions differ. Part of the recent liberalization was really the bond market. Very, very recently, there has been also more attempts to even liberalize the use of derivatives. Particularly with the Swap Connect. In some sense, it comes hand-in-hand with the bond market, because it’s the derivatives over those instruments.

We’re still at the beginning of this. You know, it’s still a difficult country to invest in, there are liquidity issues, there are credit risk issues, but, you know, it’s unusual to have a country with markets of that size that starts to open up. So I almost think of it as the reverse of the Bernanke saving glut story. The Bernanke saving glut story of the early 2000s was, look, China’s opening up. It’s really an amount of savings that are entering the global asset classes, and are chasing, for example, U.S. Treasuries, and are pushing down yields.

What we might see over the next few years, it’s sort of a reverse shock, where China is opening up, and it’s creating a set of investable assets that is expanding a lot for global savings, what you could potentially invest in. And it’d be interesting to see if China manages to do this successfully. Are these bonds gonna crowd out emerging markets like Brazil? Are they gonna crowd out the weaker, you know, developed sovereigns like Italy? Or are they really gonna show up as competing with super high and sort of very safe bonds in the U.S.? Probably that’s gonna change through time, but that’s gonna have large effects on yields. So far, that hasn’t happened in, you know, in particular, the geopolitical tensions have meant that Western investors, like U.S., Europe, have largely not re-entered China after pulling out in 2022.

Jon Hartley: That’s fascinating. It’s interesting how, I guess, how much it feels like a reversion that we’ve seen under Xi Jinping, in terms of, I guess, not being completely on the, sort of, liberalization train that past Chinese leaders have been, but at some level, it’s kind of, I think, a bit of a wanting-to-have-your-cake-and-eat-it-too kind of issue of obviously wanting to have all the economic benefits of free capital flows and international investors, but also wanting to have very strong state control at the same time. I think it can be a bit difficult, and I think that sort of segues into this next sort of topic of geoeconomics, and you’ve recently sort of pioneered this topic and concept and area of study, geoeconomics. Can you explain to us a little bit about what geoeconomics is exactly, and what your approach to thinking about it is?

Matteo Maggiori: Yeah, so I would define it simply as big countries like China or the U.S. that are hegemons using the existing trade and finance relationships from their economies to achieve political or economic goals abroad. So let me give you some very quick examples. One is, I’m the U.S., I’m trying to get European banks not to finance trade with Iran for a geopolitical reason. And one of the things I can threaten them with is losing access to the U.S. banking system if they don’t comply. That’s a very powerful threat. If you’re a European bank, that’s a death sentence if you get shut off from doing business with the U.S. financial system, and so you’re very likely to comply. Or if you’re China, you could think of a lot of the Belt and Road Initiative as I’m providing you infrastructure, I’m providing you loans, but I’m also asking in return for you to give preferential treatment to some of my exporters. I might want to control one of your key infrastructures, like a port, or I might ask you to have a particular, you know, leaning in UN votes. Those are all typical examples of this kind of economic statecraft.

And it’s something that economists were keenly aware of and working on in the 1950s. Then we dropped a little bit of the ball on this. The political scientists have actually kept thinking about this very hard, and so geoeconomics has a long history. I think what we’ve been doing is trying to bring modern economics into it, just thinking hard about, you know, clarity, like, from a theoretical perspective: when do you have power? Why do you have power? How do you use optimal policy? But also, once you make it precise, you can go and measure things, and you can do policy counterfactuals. So, you know, our argument has been that a lot of macro, international, and finance theory that was developed in the last 30 years has very good things to say about these topics, we just haven’t really focused, and so we’re trying to bring it to bear, and it’s been… it’s been great, actually, it’s been exciting.

Jon Hartley: And I think at some level, too, just the whole topic or tool of sanctions seems to have grown a lot. I feel like maybe 20 years ago, there’s the Iran sanctions that would kind of go back and forth. But even recently, I remember, maybe in 2017, 18, when I was working at Goldman Sachs, I remember that Venezuelan bonds were being sanctioned by OFAC at the time, which is the Treasury Office of Foreign Assets Control. And so that had had a huge effect on Venezuelan bond prices, and now there’s we often hear about sanctioned individuals, there’s all sorts of,

And of course, places like China and Russia have counter-sanctions on American individuals, or people are banned from entering those countries, and so it does feel like, with the sort of rise of China, and also with what’s been happening with Russia, particularly since the Ukraine invasion, that there’s been, I guess, a lot more discussion of these sorts of things. You know, what should the U.S. or the Allies do with the frozen Russian reserve assets and so forth? So it seems like your timing couldn’t be better in this. What, I guess, what would be the… explain, I guess, maybe how does that work? Is this largely, like, I guess, theoretical frameworks? How would you, I guess, maybe empirically think about certain sets of geoeconomics. I feel like the toolbox is so broad in the sense that you’ve got individuals, you’ve got financial assets, you’ve got countries that you can just sort of, I guess, ban flows of some form of assets into, or ban a certain country from accessing banks. What do you think about the various variety of geoeconomic tools in the work that you’ve been doing in this subject?

Matteo Maggiori: Yeah, so, let me give you an answer in three parts. First, you know, touching to your earlier argument, you’re totally correct. There has been a resurgence of the use of these instruments. Probably, you know, particularly in the last few years, which really the recent past, the last three or four years, this is the biggest change we’ve seen to the world order, certainly in our lifetime, and probably since the Cold War. So this is a pretty drastic change. You know, it’s shown up in sanctions, in export controls, it’s certainly shown up in the number of threats, the use of tariffs. It’s really a big change.

The second part is, you’re also correct that the the canvas and the set of tools that has been used, is quite varied. So a lot of what our theoretical work has been doing is trying to put this in all-in-one framework, where you’re really thinking about threats. There could be threats not to buy, for example, like a tariff or a boycott. There could be threats not to sell, like an export control. They could be financial aid, they could be enforcement tools. It’s actually quite possible to take all these different tools, and bring them together and figure out how they enter, like, an economic model. They generally, I would say, enter through a participation constraint. And I’m trying to get you to do something that you don’t want to do. And either I’m moving your inside option, so I’m trying to make the world better for you, and asking you something in return. Or I’m trying to worsen your outside option. I’m telling you that I’ll make your life very difficult, if you don’t comply.

And a lot of our standard toolkit fits into this. Now, to make it concrete, it’s probably easier to follow at least one example. So, let’s suppose that we focus on the threat not to give you access to something, like an input. Okay, and we can make it semiconductors, or we can make it financial services. So it’s something that you need, that is part of your production function, it’s how you sustain economic activity in your country, and I would like you to do something that you don’t want to do. So my threat is going to be that if you don’t comply with my ask, I’m going to cut you off from these inputs.

Well, the first thing that becomes pretty clear is I can try to compute how bad is this for you? At the end of the day, whether you’re not gonna comply or not depends on the distance between the inside and the outside option. If I ask you for the moon over something that doesn’t cost you anything to lose access to, clearly you’re not going to comply. So a very simple concept of power, which we call micro-power, is just trying to measure these gaps.

Now, if you think about it as an economist, then it becomes clear that what matters is, well, can you get this from somewhere else? So that’s elasticity of substitution versus other varieties that are produced by other countries. The typical example I give is oil. If I’m the producer of one variety of oil, I have no power. If I cut you off, other varieties are sufficiently close substitutes.

Now, if I’m OPEC and I control, at least in the 70s, potentially all of the varieties, then I might have a lot of power, because the next thing that matters is, okay, if you cannot get it, how important is this for your production function? Does it enter as a substitute for many other things, or is it close to, like, a Leontief input? Something that, without it, a lot of production will collapse?

The other thing that you start thinking about is, do you have a domestic alternative? Maybe you cannot get it anywhere else in the world, but you can get it in your own country. In fact, normally, the first port of call when you get cut off is your own domestic economy. Do you have it? Or can you easily produce it? You know, a typical example is semiconductors in China right now. If we tell them that they cannot have access to advanced semiconductors, they’re clearly going to try to produce them domestically, and the question is, how quickly and how efficiently can you produce them?

So, if you take this very, very basic framework, one thing that you can do is you can use a sufficient statistics approach. You can say, look, with a model, I’m gonna figure out that in a large class of these questions, all I need to figure out is expenditure shares and elasticities of substitution, and then the model might tell me which of these things are essential to you or not. It’s something that, you know, trade economists have done for a lifetime, but you can bring it to bear to these questions. So that’s one approach, and you can see that you’re going from a theory to measurement and to counterfactuals, where you’re thinking about a world where I might cut you off. But we’re measuring it from data that we see on the equilibrium path.

Recently, so we’ve been experimenting a lot with that, recently we’re taking also a different approach, which is closer to what our colleague Nick Bloom, for example, has done for years, thinking about text from the firms. The firms themselves might be talking about it. What are they doing in response? How expensive is this? And so we’ve been experimenting with artificial intelligence, which is really, the way I think about it is there’s nothing else as a technology that lets us extract so much more information out of the text compared to a simple command find, or if you’re more sophisticated, like a bigram. And that has been fun. We’ve been sort of looking at all the firms around the world and how they’re responding to these issues.

Jon Hartley: That’s fascinating, and I guess, just to get into these big data projects, you’ve been working on what’s called the Global Capital Allocation Project that you run with your co-authors, for a good number of years now, and my understanding of it, and correct me if I’m wrong you’re collecting all this fantastic data on capital flows, and I’m just curious what are some of the challenges, what some of the challenges have been with international economic data that’s usually compiled from the IMF, BIS, the World Bank, and so forth, and what’s been missing in this data on things like capital flows? I know that with things like tax havens there’s some issues, and sometimes there’s just some challenges with actually getting good data, but sometimes these sort of big international institutions kind of fall short. I’m curious, what’s the… how does the Global Capital Allocation Project fit into that? And what do we not know, or what are the things that those big multinational institutions… what are the data sets, or pieces of data that they’re not tracking?

Matteo Maggiori: This is a great question. So, we started the lab back in 2017. It was myself, Jesse Schreger, and Brent Neiman, and we had really two interests. The first one was, microdata. Immediately after the financial crisis, and then with the sovereign debt crisis in Europe, it became very clear that who owned which assets around the world was an important macro question, not just a micro question. You know, when I went to grad school, at least when I started, which was the year of the financial crisis, there was this attitude of the central bank moves the interest rate, financial markets do some no-arbitrage stuff, we don’t really have to care about the plumbing.

And then AIG happened. And we kind of realized that knowing who is exposed to what, or Lehman, made a huge difference to macro. And of course people like Bernanke, Kiyotaki, Moore, and company. Those models were there, but they weren’t really as core to the to the macro finance profession as we think of them now. And they were still very aggregate.

Particularly with the sovereign debt crisis in Europe, it became very obvious that you want to know who holds those bonds, where are the losses gonna show up, are the losses going to be absorbed by the investors, or are they going to get massively amplified because it’s going to cause a cascade of failures?

The response to this was both in the private sector, in academia, and in the policy institutions, a massive effort to collect data. All of a sudden, we wanted to know positions. You know, even in finance, traditionally, we focus on prices, on returns. We didn’t spend much time thinking about positions.

That data was becoming available, and so at the time, we decided with Jesse and Brent that we wanted to jump in on this. And we got a little lucky a lot of research is, you try your best, but you also need to get lucky. Our luck was that one of the largest data sets of microdata around the world had become available commercially. This was, like, data from Morningstar. We had convinced them to give us their entire data, and that was a treasure trove, because all of a sudden you could go very, very deep on questions that traditionally, only with the aggregate statistics, you couldn’t really answer.

And so, for example, we worked a lot on home currency bias, which is pretty obvious once you have the microdata, but without the microdata, it was very difficult to see. That eventually led us to think about, okay, once you can manipulate the data and see what’s going on, what’s the right lens to look at the data? One thing that appeared very obvious to us is that a lot of positions were in tax havens. Like, you look at the Cayman Islands, the British Virgin Islands, Luxembourg, so much of the world’s financial assets, either on the investor side or on the issuer side, are in these countries.

Now, every economist understood that there’s no economic activity, or there’s very little economic activity going on in the Cayman Islands compared to the assets and liabilities, so the capital is going somewhere else. But when I did my dissertation…

Jon Hartley: you kind of had to live with this. You sort of…

Matteo Maggiori: could decide whether to drop it, dummy it, do something about it, but you couldn’t unwind it. And then it became more obvious to us that you could unwind it, and that led to a lot of research, or a pipeline for us, thinking about how do you get the facts straight when you have all these layers of obfuscation?

And that has also led to a lot of collaboration with the policy institutions. So, the BIS, the IMF, the Fed, the ECB, they have people that do fantastic work on these issues. And there’s been a collective effort to produce data that is much more representative of what an economist would want to look at, compared to a simpler statistical approach. So now we have a long-term collaboration with the ECB, where we look at, like, Luxembourg and Ireland. They’re, like, massive mutual fund centers. They show up as the biggest holders of pretty much most assets worldwide. It’s very clear, it’s not on behalf of the residents, but where do you stick this data? Like, is it Italians? Is it Germans? Is it the rest of the world? So that has been a lot of fun.

I would say that traditionally the lab, our first wave of research was all on financial positions. Now we’re working a lot more with text, which I mentioned. One frontier of research that is still out there to crack is really good data on how firms trade with each other around the world. Like, that data, particularly in goods and services, that data is very spotty. There are some data sets here and there, but if you think that if tomorrow we get sanctions and we want to know what is the exposure of every U.S. firm to foreign inputs, how does it aggregate? That data doesn’t exist. We get glimpses in some data sets, and so my sense is that with everything that is going on in geoeconomics, that’s gonna be one big, sort of, next frontier that needs to be tackled.

Jon Hartley: Yeah, my sense, just as a researcher, is, like, data on firms… yeah, especially with the U.S., internationally we have Orbis, which is terrific. But U.S. data is… it can be challenging, to work with, even just, like, the Dun & Bradstreet data. You know, you might have some sort of imputed number of employees or establishments, but it’s pretty limited. We don’t know too much about firms, and it’s also hard to find their information about their exposure to various…

Matteo Maggiori: It’s pretty difficult, but, you know, my sense is that it’s going to become doable, and a little bit like the financial positions now are very routine. And 10 years ago were very different here. You know, it’s kind of amazing how, over an arc of 10 years, the profession collectively makes a lot of progress. So I’m sort of somewhat hopeful that 10 years from now, a lot of these issues will look like routine research.

Jon Hartley: You’ve also done a lot of work, a lot of great empirical work on beliefs and portfolios. And I think you’ve shed a lot of really amazing light on investors, and my understanding is, I think you run a lot of surveys partnering, I think, with Vanguard, asking questions to Vanguard clients about their market expectations. What have you learned from that line of research when you’re actually going in, asking questions about retail investors, and there’s a lot of, I think, discussion recently about to what degree flows and quantities matter. This is a huge question, I think, in financial economics right now. Are equity markets inelastic or elastic? You know, if you had a $1 billion exogenous flow into equity markets, what would the effect of that be? And some like Koijen and Yogo argue that it’s a $5 effect. I’d argue it’s much less than that, and the market’s probably more elastic in the long run than inelastic, as they might claim. But I’m curious, like, so much of these sort of behavioral things and financial markets are driven by beliefs. What have you learned from that line of research?

Matteo Maggiori: Yeah, this was fun. This was with Stefano Giglio, Johannes Stroebel, and Steve Utkus, who at the time was at Vanguard, and the head of one of the research functions. And it was really stimulated from this perspective, so I guess two things got us into this. The first was, intellectually, there was all this work on expectations moving around a ton, and potentially leading people to trade a lot, and therefore to explain the volatility of price. This is, like, one of the most classic questions of financial economics: why are prices so volatile compared to the fundamentals?

The second thing that was interesting is survey technology was changing. Like, it was clearly very possible to run large-scale surveys, get people to answer on their phone, on their laptop that was becoming more and more available, and by now it’s totally routine. And even when we did it, certainly we didn’t pioneer this, but it was sort of clear that it could be done. And sometimes you just have to, again, be a little lucky and a little bit ambitious. So we thought, like, okay, the thing that is missing is to see people like me and you when we actually make our financial decisions in real life, not in a lab experiment. How do we react to our own reported beliefs? And can we get high-quality data that links actions in a setup that is, in some sense, the real world, these people are making their decisions on their actual savings, to high-quality survey data?

And we just got lucky, like, Vanguard was willing to do it, and they’ve been a wonderful partner, actually, as an institution on this. You know, I would love to do it with many more institutions. So far, no other financial institution said, great, we’ll let you do it. And so we ended up designing, I would say a medium-scale survey. Medium-scale, for me, means the following. It’s not one that says, hey, Jon, are you bullish about the market? The problem with that one is it’s very easy for you to understand what I have in mind. It’s very difficult for me as an economist, when I get the answer, to translate it into something that will constrain a model.

So on the other hand, you can do very large-scale surveys, where you have to be a professional economist to even understand what it is that they’re asking you. So we spent a lot of time designing in a way that we felt a relatively unsophisticated retail investor will understand what you’re asking, and has a view on this. And on the other hand, the answers are quite informative for how we design our models.

And the thing that jumped out immediately was really two facts. The first one is that beliefs do move a lot. People have all sorts of views, but portfolios don’t move nearly that much. So, the sensitivity of portfolio allocations to beliefs, it’s way low.

Now that’s a little bit different, and not to be interpreted directly as the elasticity that you have in mind, because in some sense, it’s an elasticity to reported beliefs. There are no more volatile than a rational expectations model would tell you would be the, at least for a representative agent, the expected returns. So that sensitivity was way too low. Now, that one, if you take it at face value, is not great news for the behavioral approach, because it tells you the beliefs could move a ton, very little trading, of course, and therefore this is unlikely to generate, at least in a very naive model, huge price corrections.

Now, there are ways to go around it, which is to think about, like, different sizes of investors, maybe there’s a small fringe of investors. The statements need a lot more to be complete. But that fact was pretty surprising, pretty interesting, and as has surfaced in different fashions, by now in lots of different studies.

The other thing that showed up is how people change their mind over time. So, when we started, we had the following question. Is the right view of the data that you and I change our mind a lot over time? Or is the right view of the data that you’re always very optimistic, I’m always very pessimistic. We both change our mind, but the first-order effect is just how far are we in our beliefs to begin with?

The world is really the second. Like, these individual fixed effects absorb a tremendous amount of the panel of beliefs. So there’s really optimists and pessimists. It’s a very persistent effect. And we never found it easy to explain, based on observable characteristics, why in the first place is Jon so optimistic and Matteo so pessimistic. That’s still an open question. But that has been a it’s been a very fun, somewhat unusual line of research for me, because it’s not in international, but I thought it was fascinating, and we keep working on this. We keep sort of adding pieces of evidence over time.

Jon Hartley: That’s fascinating. I’m curious, like, I do follow, like, some of the behavioral literature and some of the both intersections with, sort of, macro and finance. And, like, I remember there’s all these papers by, I think, Mian and Sufi, and there’s a whole literature out there that tries to look at, like, consumer confidence, and how much does consumer confidence actually matter for real economic variables? And I’d say this is kind of maybe analogous to that, and sometimes they look at, like, elections, for example, and this is almost like, I feel like a universal law, but basically, following an election, you can see, around these periods if, for example, an incumbent gets thrown out of office, there’s a massive shift in expectations, or in consumer sentiment. Basically, people feel very good when their own preferred candidate’s in office, and they generally have positive economic sentiment for people that belong to that political party, like, for example maybe after the most recent election, you’d… I’m sure you would observe that the consumer sentiment of Trump voters would be very high, probably right now, versus Democrats. And so… and these things flip around elections, like, pretty mechanically, and using that for identification, I think some of these studies, like the Mian and Sufi studies, basically found, like, no real economic effect. So I think that kind of maybe speaks to some of your findings. I’d be interested if you’ve ever looked at how these sorts of beliefs change around elections, if maybe people sell their portfolios around…

Matteo Maggiori: So, we looked a little bit, but part of the problem is it’s not easy for us to identify who’s a Republican, who’s a Democrat. You know, one of the great things with working with this type of data sets is I get to see all your wealth and all of that, but precisely because of that, there is a strong limit on not being able to identify people, so that’s I guess, part of what you get and part of what you don’t get.

But in general, I’m a huge fan of studies that are trying to figure out how my beliefs or my perceptions really translate into actions. One thing that, for example, was shocking to us is, during COVID, and then more recently, during April 2nd, the announcements of tariffs, we looked at changes in beliefs. And there were massive changes. You know, people became very pessimistic about the economy, the stock market. But when you look at their portfolios, it was shocking to me how little they sold. You know, you would think if people become so pessimistic, you would find in the data a massive attempt to liquidate equity positions. In reality, that’s actually pretty small.

And I was speaking to my co-author Xavier, and we haven’t worked on this together, but Xavier Gabaix has worked on this in another setup, and it’s sort of shocking how little it is.

Now, whether that translates from big or small asset price movements, that requires a whole sort of different set of assumptions and baggage that comes with it. But just as an economist, compared to at least my informed prior, these flows are pretty small. The question is, are we mismeasuring beliefs? Are we… is the problem the way they’re responding? It’s just interesting, it’s a mapping that I think is gonna take more time for the profession to fully absorb. But it’s certainly striking how big our largest differences are.

Jon Hartley: Yeah, it’s fascinating. I think behavioral macroeconomics and behavioral macro finance, if you call out a field, it certainly is one. Finding good answers to that, I think, is such a difficult thing to do, and it’s certainly huge gains if people can make, even, I think, marginal improvements in our understanding in that space that that’s convincing.

I want to just spend, I guess, our last moments here together talking about exchange rates. And one core… it’s really a core area of international finance, and you published, at length about exchange rates. I’m curious. I want to tell us a bit about your own research on exchange rates, but I’m just curious, in general what in your mind have we learned about exchange rates in the past, maybe, 20 to 30 years? And maybe it’s… we’ve learned more, I guess, from getting better data. I feel like we’ve had okay exchange rate data. In general, maybe we have more high-frequency data now, but we kind of had these periods where one, like, I think a lot of international economics is born out of the Bretton Woods era. I think Mundell-Fleming, the Mundell-Fleming trilemma of the idea that you can only have two, out of fixed exchange rate, independent monetary policy, and free capital flows. It was an idea that was developed out of the IMF when Fleming was working there, and I think Mundell was maybe visiting. But obviously, the world’s moved away from the Bretton Woods system.

In the 70s closing the gold window and the Bretton Woods system breaking up. Keynes, obviously, I think in the 40s, when he was helping to create the IMF and the World Bank, he was in favor of having one international currency, being the Bancor. I feel like we’ve sort of gone all over the place, and there’s, in terms of what we believe about exchange rates. In the 60s, Milton Friedman went head-to-head with Mundell about should we have fixed or floating exchange rates, and Friedman, I think, kind of won out for a while, but there’s still many, many countries around the world, even today, that still have fixed exchange rates that are pegged to the dollar, or in some cases, to the euro. But I’m just curious, what there’s all these exchange rate puzzles that are out there. I’m curious, what do you think we’ve learned as a discipline in the past few decades about exchange rates?

Matteo Maggiori: Well, this is a huge question, so I’m gonna tell you a little bit of what I’ve worked on, or what I found fascinating, also because it’s a good story, connects to your very first question, so it’s a good wrap-up of how I got into economics. Because, you know, I mentioned I worked for a while as a trader of currencies and interest rates at JP Morgan. And that was before my PhD. And then what happened is I was on the job market. I had a paper that was on international, was on the role of the dollar, and, you know, the U.S. as a world banker. Xavier Gabaix and Emmanuel Farhi, at the time had a paper on exchange rates and rare disasters.

And I wasn’t on the job market, and I ended up speaking to Xavier on a flyout, and we were both pretty unsatisfied with how exchange rate modeling worked, even in our own papers. And we sort of had in mind a different model, and we couldn’t really make it work, and so we thought, like, oh, why don’t we work together on this? Which, of course, for me at the time, was a great opportunity, because he was already, like, an incredibly established and talented economist. It still is, but I was just a rookie on the job market. And I thought, okay, great, let’s do it.

And I ended up thinking about this through the lenses of what I had seen, trading exchange rates, which was a very simple idea of, suppose that, you know, today we wake up in the U.S., and there’s a bunch of people that really want to hold Brazilian real risk. They’re very excited about the prospects of Brazil, they want to buy those bonds. Well, who’s going to supply them? It’s not going to be some long-term issuer in Brazil. Probably it’s gonna be, you know, before a financial crisis, some bank like JP Morgan or Goldman, now it’s probably some mutual fund that is the marginal intermediary, somebody that is willing to take the other side of that trade, and so it’s giving up Brazilian real, and it’s getting dollars.

And it’s using their balance sheet. These institutions are big, they have large balance sheets, but, you know, if you’re trading a few billions, you’re kind of moving their risk. And so they’re thinking in equilibrium, do I make enough money out of this trade to justify bearing the risk? And so we ended up designing a model where the limited risk-bearing capacity of these intermediaries in the middle is sort of crucial. If you’re pushing dollar risk on them, and you’re taking away real risk, the exchange rate has to move to guarantee enough returns to these intermediaries to hold the flows. In particular, that’s going to cause an immediate appreciation of the real, so that over time, you can depreciate, generating gains for them.

And so it’s a model that linked flows and financial frictions and intermediation to exchange rate determination. And it’s an idea that actually had been around for a long time. Like, Pentti Kouri was an economist in the 70s talking about this, but it was surprisingly difficult to make it stick in a modern micro-founded general equilibrium model. And so that’s what we ended up designing with Xavier. It’s been a very popular model ever since. It’s been, you know, adopted a lot in academic research. The IMF, when they revised their policy framework, the financial market side of their exchange rate determination comes… builds on that paper. So it’s had, you know, a fair amount of impact over the last… I guess it’s already been more than 10 years, so almost 15. But for me, it was fun. It was a paper that sort of translated an industry experience into an academic framework that holds together. And I, you know, I didn’t go through the industry thinking that that was gonna help me write those papers, but that paper was a pretty direct descendant of that experience, so that has been fun.

You asked me what have we learned and what we’ve not learned. I think I would say that we’ve learned that this market segmentation, it’s pretty important, that these flows do matter, they do move exchange rates around. It opens up a toolbox also for policy. We still don’t have a lot of empirical success. I would say that there’s plenty of evidence of financial frictions being important for exchange rate determination. I wouldn’t say it’s overwhelming. And I think that that’s where there’s excitement about positions data. Exchange rates are particularly tricky, because you would think that some of the financial institutions that are most likely to be marginal in these markets are those whose data is the hardest to get, like hedge funds, you know, very levered players. These are probably pretty important, and it’s pretty difficult to get a complete picture of what they’re doing. But again, there’s been an incredible amount of progress on this.

Jon Hartley: Yeah, it’s a great question. And, at some level I think it’s just very difficult questions in terms of what actually predicts exchange rates, in the short to medium run. I think it’s very hard. I think in the 2000s, there were a lot of both currency and commodity hedge funds out there that now largely don’t exist. There’s a lot of multi-strategy funds that trade various currency strategies, FX carry being one big strategy, and there’s been tons of work in academia that’s been done on covered interest rate parity and arbitrage that’s sort of broken apart. It’s one big area.

I think maybe one theme in your work, which I think is terrific, and in my sort of young research career here, try to do some of this, which is I think there’s such a big chasm between academia and practice, and I think if as researchers, we knew everything that practitioners knew, we could write better research papers. And it’s challenging in part because there’s a lot of data that they can’t share or don’t want to share, and they also don’t want to give away their trade secrets at some level, but I think there’s still so much to be learned there, so it’s fantastic to hear. I’ve read Gabaix and Maggiori, I think it’s a fantastic paper, and I didn’t quite realize how important it was by your JP Morgan experience, so I think that’s terrific.

I guess, like, one last sort of just question, I guess, or sort of big thing here is, any thoughts on, I guess just the future of the world? You’ve written, in sort of these hegemons you’ve written, really, the canonical papers on the sort of topic of hegemons, with Emmanuel Farhi and others. You wrote a great paper several years ago that talked about the decline of the euro, which was something we’re continuing to see.

I think the U.S. dollar has held up quite a bit, held up pretty well, I think, even through the Russian invasion of Ukraine, through COVID, through the recent early 2020s inflation, the dollar, I think, as a share of global reserve assets is pretty much still the same. And I think this is the same across invoicing, a number of things. China, I think, hasn’t made, at least as a share of FX reserves, the same kind of, I think, progress that some people had hoped. There’s all this talk about BRICS bank and de-dollarization, which I think is not well found in the data, but, you know, so many of these things also are sort of proactive and are new, and maybe it takes time for things to change. But I’m just curious, what your thoughts are about the trajectories of China, of Europe, of the U.S., and of elsewhere. And I just, I think back to this one speech that I once heard, from Stan Druckenmiller he’s been around for a long time in investing and played a role in breaking the Bank of England, and he said at one point everyone thought the USSR was gonna take over the world. They were wrong. Paul Samuelson wrote in a textbook, he thought that the GDP of the USSR was going to eclipse the U.S., and that was obviously wrong, and he updated his textbook. At one point in the 80s, people thought that Japan was going to surpass the U.S. That obviously was wrong. It’s been wrong since the 90s.

And next is sort of the China question, and I’m just curious you study this, you study all these areas. I’m just curious if you sort of had any sort of big thoughts. Obviously forecasting is always challenging, but I’m just curious, what do you think in terms of how these big hegemons are shifting?

Matteo Maggiori: Yeah, so, one thing is for sure, which connects to what we discuss in reputation models, is that challengers come up, but it’s very, very difficult to displace the U.S. Ultimately, the institutional strength of sustaining large markets with big foreign participation, where even in a crisis like ’08, you don’t essentially try to pursue policies that intentionally reduce value for foreigners, it’s an incredible promise to maintain. It takes a lot of institutional strength. And most countries want to make that promise ex ante, because you get good terms on your borrowing, and when the time comes, can’t fulfill it. So it’s not easy to build a reputation and maintain a reputation at these levels.

So I’m certainly skeptical of each time there is some promising young entrant thinking that it’s gonna be so easy to displace the incumbent. On the other hand, it’s very clear that we’re seeing a big deterioration in the U.S. The fiscal situation has changed dramatically. You know, we’re not quite in trouble, but we’re starting to approach debt levels where these issues are going to come up. If interest rates spike, the cost of servicing the debt is going to go up, and you also don’t want to go to the other extreme. If you look through history, it’s not as if once you established yourself to be a cornerstone of markets, you will always be one. In fact, you can be one for a very long time, but history shows us that you can often put through policies that lead to your own demise.

So, I think the truth is somewhere in the middle, but one aspect that I think I’m focusing on these days is the difference between the implications of the rise of, for example, an alternative like China, for macro versus power balances. Let me put it this way, which is a little simplistic, but makes the point. You mentioned that China is somewhere around, like, 2–3% of the international use of currency, depending on which exact measure you use.

Jon Hartley: And the rest is the U.S., which is, like, 50–70%.

Matteo Maggiori: Now, let’s quickly agree to a scenario where, 10 years from now, the U.S. is still in the high 50s, China’s gone from 3% to, let’s say, 7% to 10%. Okay?

I have no idea whether this is likely or not likely, but we’re not talking about neck-to-neck. We’re not talking we’re 50-50. Now, what’s the consequence of that? I would say for macro, relatively little. I don’t think it’s gonna change the transmission of monetary policy, the way exchange rates work, tons of the usual stuff, very, very little. But now, go back to the question of sanctions or exerting power through the financial system.

For that question, this is an absolute disaster. Why? Because imagine sanctioning a country the size of Brazil or Russia. If China is 10% of the usage, that’s plenty of liquidity for them to conduct business with. So power is really about concentration of the shares, and coming down from having 95% of the shares to 85 is a big loss in your power compared from 85 to 75, and so on.

So I think I always invite people to be careful about how we interpret those shares, because what they mean really depends on the question. So if China, for example, develops a successful payment and settlement system that is pretty liquid, and can easily accommodate a small open economy using it, that’s a big loss to Western power. Does it make a huge difference to many other questions in macro? Probably not.

So those are also much more realistic than a world where, in the next 5 years, China is 50% of the world financial system, which who knows, but seems rather unlikely. And I think it leads to a bit of a policy mistake, because if you’re thinking that none of those issues are going to arise until we’re really neck-to-neck financially, then you can be very complacent about the development of China financially, because it’s going to look small for a very long period of time. But those small shares can make a very large difference, particularly in geoeconomics, even if not in macro.

Jon Hartley: I think it’s just so hard, I think, at some level, to dislodge a hegemon. You think about the last time the world hegemon global reserve currency changed. You know, it took a couple world wars to basically dislodge the UK from having the pound as the world reserve currency. And in a world where we have nuclear weapons across many countries war becomes increasingly less likely to happen.

Matteo Maggiori: We might end up living in a world where fragmentation really means on the edges, and where the U.S. is still very, very dominant, but all of a sudden, there are two or three other players that can provide meaningful, for example, financial services. Now, that world for power makes a big difference, even if it doesn’t look at all like a complete reversal of the current equilibrium.

Jon Hartley: Fascinating, yeah, absolutely. Well, it’s a real honor to have you on, Matteo, and talking about your amazing career and contributions in international finance.

Matteo Maggiori: Fantastic. Well, it was great to do it. I’m glad that we got to do it.

Jon Hartley: Well, it’s a real honor to have you on. This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Don, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Don Brash, who was governor of the Reserve Bank of New Zealand for 14 years, from 1988 to April 2002, where he was the first central banker to pioneer inflation targeting across the world. He also was Leader of the Opposition and leader of New Zealand’s National Party from October 2003 to November 2006. Thanks so much for joining us, Don.

Don Brash: Very welcome.

Jon Hartley: It’s a real honor to have you on, and really… You know, I think inflation targeting, is often seen as a huge, massive policy success on the part of central banks, but I think a lot of people aren’t fully aware of its origins. So, I want to get first into your personal origins. How did you originally get interested in economics growing up in New Zealand, and going on to do a PhD and play a role in economic policy in the 1980s and 1990s, sort of at a key time of market reforms in advanced and emerging economies? a lot going on in the 1980s, and just from a market reform standpoint, New Zealanders, I think, floating the New Zealand dollar, reducing tariffs, and so forth. I also know that you’re a Kiwi farmer. You also, I think, share some policy and farming, cross-interests with Hoover’s very own Victor Davis Hanson, who farms almonds. And you also have an autobiography, called Incredible Luck. I’m curious about your personal origins, you know, were there any other New Zealand economists that you looked up to, for those that aren’t aware, Bill Phillips, who’s the namesake of the Phillips curve, is also a New Zealand economist. I’m curious, how did you first get interested in economics?

Don Brash: Well, I was mainly interested in foreign policy. I was very much preoccupied with the causes of war. Because I grew up in the immediate aftermath of the Second World War, and I was working out how I could possibly make a difference in international foreign affairs. So my undergraduate degree was mainly in history. And economics, equally, actually, but history was a much stronger, faculty at the time. And but when I finished my bachelor’s degree with a history, very good marks and so on, I couldn’t see much history, much prospect for my career in history, so I thought, I better get into economics. And I went to the Australian National University to do a PhD, Having done a master’s thesis in New Zealand, saying how bad and awful and terrible Foreign investment was, or external debt was. And I went to the Canberra Australian National University, convinced that I should do a much more in-depth study of the effects of foreign investment, and by chance, I got the opportunity to do a detailed study on 100 American-affiliated companies in Australia. I started off in tent. to prove how bad they were for Australia, and to the great embarrassment of many of my friends, I reversed 180 degrees, and I realized that American investment had been enormously beneficial to Australia, and that sort of started me off on a pro-market track. I went from there to the World Bank. I spent 5 years there, learned a great deal. It was the time that Robert McNamara was president of the World Bank. I learned a lot from him.

Jon Hartley: You’re working in the U.S, right?

Don Brash: In the US, in Washington, D.C.

Jon Hartley: Wow.

Don Brash: A part of that time, I was on the staff of what became known as the Pearson Commission on International Development, but named after Lester Pearson, the former Prime Minister of Canada, who chaired that commission. There were 6 or 7 of the good and great of the world on that commission, and there were 12 staff, of whom I was lucky enough to be one. And I was the person advising them on the role of private foreign capital in economic development. So that, in a sense, started me off on an economic track rather than a foreign policy track. I came back to New Zealand, ran an investment bank for 10 years, affiliated with Wells Fargo Bank, so I had a connection there again with the United States. Then, at that point I made a false attempt to get into politics, didn’t work. So then I got right out of banking and became chief executive of what was then called the Kiwi Food Authority. Which coincided with the fact that I had just bought a piece of land and planted it in kiwifruit vines. And that explains why, to this day, I still have an interest in a kiwifruit orchard. It’s a great product. I was then asked to amalgamate what in America would be called savings and loan institutions. There were 9 of these rather weak institutions, and I was asked to put them together. And I was… had done that for 2 years, when all of a sudden I was asked to be governor of the Reserve Bank. I should say that during that previous time I was at the Kiwi food industry, the… the Labour government, which is our… ostensibly our left-wing party, asked me, or their finance minister asked me to do a number of things for the government in the economic policy space. And, the most significant of these was the… This is because Roger.

Jon Hartley: Roger Douglas, who’s the finance minister.

Don Brash: That’s right.

Jon Hartley: Known for market reforms at that time, I guess, floating the kiwi dollar, the New Zealand dollar, tariffs, financial deregulation.

Don Brash: quite right. He was the most market-oriented finance minister in New Zealand history to that point, and did things which I thought were inconceivable for a center-right government, let alone a center-left government. I was mainly involved in that particular period, as far as government policy was concerned, on tax policy. And he asked me to chair a three-person committee to design our value-added tax, which we call a goods and services tax. Now, you can debate the merits of taxation, but if you’re going to have tax. A goods and services tax, or a value-added tax, is about as good as it gets. But most countries have attempted to create exemptions, different rates, etc, for different goods. So you exempt, for example, children’s clothing, or books, or food, and in no time at all, you have a much more complicated system to implement than we had in New Zealand. Thanks to Roger Douglas. more than thanks to me as chairman of the committee, we have a GST which is as good as any in the world, with a possible exception in Singapore. Both countries have A goods and services tax, or valuated tax, which is equal across everything with no exceptions, which makes it extremely simple to implement. And that was my, to that point, my greatest contribution to policy. But then, as I say, Roger Douglas asked me to be governor, of, of the Reserve Bank. And that’s, of course, when I started getting involved in monetary policy and inflation and so on.

Jon Hartley: Fantastic. So, 1988 is when you became governor of the Reserve Bank of New Zealand. I’m curious, in inflation targeting, the inflation targeting regime was put into place in 1990. I’m curious, tell us the story of how this all came together. I know there was a famous interview in which you went on TV, and you said, you know, you, I think favored a 0% to 2% target. I’m curious, you know, was there a lot of academic. thinking, or was it more, you know, personality-driven? I’m just curious, how did this whole, idea to have an inflation target come about? I know, like, you know, prior to inflation targeting, explicit inflation targeting regimes. You know, for example, the U.S. briefly had a monetary policy targeting regime that was going on in probably around the same time, in the late 1980s, I think, in the Volcker Fed. I’m curious, like, what was being discussed at that time? You know, did… the central bank and the government at the time, at least, you know, did they buy into, sort of, Milton Friedman’s idea that inflation was always and everywhere a monetary phenomenon, which it wasn’t exactly a common belief in the 1970s, for example, when there were a lot of price controls and things like that. I’m curious, how did this whole idea to start inflation targeting come together?

Don Brash: Well, the background was that we had had inflation, which by developed country standards was quite high. Not… not like Turkey, or not like South Africa, not like Zimbabwe, but nevertheless, fairly high, double digits, between 10% and 15% for several years in the end, and poor growth. And that was a useful exercise in one sense, because it showed that tolerating more inflation did not give you more growth. Our growth was quite modest by developing country standards, despite, or because of, this, this fairly high inflation. But… but let me go back one… one step. Prior to 1989, And I say 89 because that’s when the Act was passed. There were two kinds of central banks in the world. there were the completely independent central banks, at least notionally, the Fed being the most obvious one, but also the Bundesbank in Germany, Swiss National Bank in Switzerland, and so on. But that was about all. There weren’t very many of them. Most central banks were effectively a branch of the Treasury. They did as the government of the day told them to do. And that meant that monetary policy was quite cynically manipulated, By the government in power. And, and… The 1989 legislation pioneered a new track. The government said, look, the inflation rate is something which the government should decide. What rate does the government tolerate its currency devaluing. In other words, what inflation rate are they willing to accept? It’s a political decision. But how they deliver that should be up to the technocrats in a central bank. And the unique thing about the New Zealand Framework at the time Was that if the inflation rate choice in the hands of the addicted government. And told the bureaucrats in the central bank, to deliver it. And the inflation rate, which the government wanted, had to be public in writing, and everyone knew what the target was. The government couldn’t fudge it. And the central bank had to deliver. Now, when I said central bank. When the 1989 legislation was first drafted. It involved a contract between the Minister of Finance and the Governor personally. And I recall saying to the Minister, as it was being drafted, surely you want a contract with the Reserve Bank? And he said, no, we can’t fire the Reserve Bank, we can’t even fire the Reserve Bank Board, but we sure as hell can fire you. And it was therefore a very personal responsibility for the governor at that time. It’s changed more recently, but at that time, and for the next 20 years or more. The responsibility was on the governor to deliver a contract, which was in writing. Where the government chose the target inflation rate. Now, the beauty of that is. That if government… if the central bank has a tight monetary policy. It’s doing it because the government has mandated the inflation rate, which the, the Reserve Bank must deliver. So, unlike the situation you have in the United States right now, where the president can criticize the Fed for not dropping interest rates, he’ll be the first to complain if inflation gets out of control. But in the New Zealand framework, the government can’t really criticize the central bank. As long as the inflation rate is within the mandated target. So, that’s created a totally new framework. It’s the framework which has been adopted, of course, since that time, by Australia, by Canada, by Sweden, by UK. But it’s where the government has responsibility for nominating the inflation rate. and requiring the central bank to deliver it, or in our case, originally, the governor of the central bank to deliver it. So, that was a unique framework, but when you’re going to structure a framework like that, you have to have, in some sense, a numerical target. What does the government want for the inflation rate? Well, the 0 to 2 I think came out of an interview with Roger Douglas on television. Shortly after the New Zealand inflation rate dropped below 10% for the first time in some years. And the television reporter said to Roger Douglas, aren’t you satisfied now? You’ve got inflation under 10%. And they just replied, no, no, I’m looking at, like, zero, or zero two. And it was a flippant, off-the-cuff remark. when he sort of made the 0-2 comment, and it became, of course, Holy Gospel. When I became governor, some six months later. That was the target I was told I had to meet. Now, at that point, it was an informal target. And when the legislation was passed in 89, requiring a written instruction to the central bank on the inflation rate, that’s when we formally adopted the 0 to 2 by 1992, because we were at a higher rate of inflation by that time. In the early 1990s, you know.

Jon Hartley: So, if I guess… my understanding is, and later it shifted, from, you know, 0 to 2 to, I think it’s 0 to 3, and then, and then eventually 1 to 3. So, eventually, you know, 2% became the middle of the band. I mean, it’s fascinating how like, one, I guess 2%, which we hear about today, and 2% inflation targeting, why it’s important that we target 2%. Originally, it was the upper part of this band, that was… somewhat… I don’t want to say randomly thrown out there as a number, but is there any information in terms of any kind of academic input into this? Was there… or was this just a sort of arbitrary set of numbers that Roger Douglas had come up with? I mean, was there any… ahead of that TV interview, was there kind of any, I guess. discussions between the central bank, or economists, or, I guess folks in the legislature, or is it… was it just really a kind of an arbitrary thing that we’ve now all sort of coalesced around?

Don Brash: Initially, it was rather arbitrary in the way I’ve described. Subsequently, we rationalized it as 1% measured inflation. is probably akin to actual inflation. Yeah, actual inflation. Is it zero? 1% measured inflation is probably equivalent to price stability, because of biases in the measurement of the consumer price index. I think that you had a Senate committee in the United States, I think it was the Boskin Committee. Which is…

Jon Hartley: named after Hoover’s very own Michael Boskin, who’s a senior fellow on the staff here still.

Don Brash: Okay, okay. And I think, from memory, that committee estimated at a 1% bias in the US measurement of the CPI. I think, actually, that took place after our 0 to 2 was established, but we rationalized it subsequently as being Genuine profitability, plus or minus one. That’s where we rationalize 0 to 2. Now, subsequently, we decided there are so many exogenous shocks. Which hit a small economy in a trading environment. That the target was undesirably narrow. So he toyed with the idea of having a target of minus 1 to 3, In other words, same midpoint of 1% measured inflation, which we regard as tantamount to price stability, but a slightly wider brain before the governor was at risk of losing his job. Then we thought, actually, if measured inflation was tracking below zero. The chances are we’d be easing pretty aggressively. So we decided minus 1 to 3, while it had the symmetry of being… retaining the 1% target. Was a bit artificial, so we changed it to 0 to 3 after political negotiations in the mid-90s between political parties. Subsequently, we… it was also agreed that, and bear in mind the fact that the target is mandated by the elected government. that were inflation tracking towards zero, again, would be easing fairly aggressively. So the target was eventually changed to 1 to 3, hence the midpoint of 2.

Jon Hartley: Well, it’s… I mean, it’s fascinating, that, one, I guess, the arbitrary nature of it… so, one, the Boskin Commission, I think, didn’t have until maybe 1995, 1996, a good number of years later.

Don Brash: Of course.

Jon Hartley: You’re right, I think… the Reserve Bank of New Zealand, I think, figured out what they had figured out years… I think, years later, that, you know, there is this, you know, maybe 1% bias. But I’m just curious, I know some of the history in the U.S. and Canada, that, you know, for example, Paul Volcker. you know, through the rest of his life, you know, favored a 0% inflation target, and he was, I think, a very big critic of 2% inflation targeting for many decades. I mean, obviously, you know, very few central banks heeded those words, I think, but, But I’m curious, I know, like, John Crow at that time, who was the governor of the Bank of Canada. He favored a 0% inflation target originally, or a lower one, I guess, maybe 0-1% inflation target. And then at the time, I think what had happened was, you know, there was a Liberal government in power in Canada, the early Chretien government, and essentially the, the Chretien-Martin government wanted a higher inflation target because, you know, they sort of believed in the Phillips curve sort of concept that you could maybe create more jobs by letting inflation run a little bit hotter. And in the U.S, you know, the Fed never really even announced its official inflation target until 2012 under the Bernanke Fed, even though, sort of, it was, I think, a… pretty well, known, poorly kept secret that the Fed was targeting 2%. But I’m curious, you know, when you were a central banker at that time, I mean, when sort of the… The 2% consensus hadn’t formed yet. I’m curious, what were those conversations like with other central bankers? I mean, was there sort of a… I mean, we… nowadays we have these sort of cross-country macro debates now, about all these things, you know, what should our monetary regimes look like, and often our shocks are increasingly similar and more globalized, it seems, but I’m curious, like, what were the conversations like back then? Was there a battle for 0% inflation targets? that, that was going on that sort of eventually lost out, or… and I’m curious, another thing that you often hear, like, from folks like Ben Bernanke, when he was chairman of the Fed, defending the 2% inflation target in the 2010s, when people were bending over backwards, you know, because the inflation was running below 2%, and how some people made the case it was sort of an emergency that that we weren’t hitting a 2% target. I’m curious, like, one of those arguments that people make is that, well, you know, we should be afraid of deflation, and if we had negative inflation, that people would be saving tons more and reducing their consumption, and this could make economic contractions much worse. Were there any sorts of conversations like that happening back in the late 1980s, early 1990s, when the sort of inflation… early inflation targeting regimes were being set up?

Don Brash: I don’t remember them, to be honest. We were so pleased to get inflation below 2 and regularly around 1, that the idea of getting it below zero didn’t really have much appeal, or any public currency either. One of the strange… you mentioned the Greenspan Fed. One of the strangest things about the Fed, it seemed to me, was that they had an inflation target, but were scared to mention it. And I think that’s odd, because for me, the inflation target plays a very important role in expectations, and therefore in behavior. And one of the great things about a small country, which, of course, the US is not, is that the governor can and could and did spend a lot of time going around talking to Rotary clubs and farmers’ groups and church groups, anyone who would listen. To convince the public that we were deadly serious about getting this inflation to the target. Because expectations are pretty important, and they’re important also in terms of the social cost of delivering an inflation target. If people genuinely believe the inflation rate is going to be 1%, Or 2%, or whatever the target is. their behavior tends, to some degree, to gravitate to that kind of target. It makes the job of monetary policy that much easier.

Jon Hartley: You know, at that time, in the late 80s, early 1990s. Were there surveys established yet at that point that could track long-term inflation expectations? Like, in the U.S, for example, there’s the University of Michigan surveys that we have here that have been going, I think, since the 1960s, or quite some period of time. And I know, I mean, there’s many other expectations measures now that exist, and surveys that exist. Policymakers obviously follow this very closely. They also follow, you know, maybe inflation-linked bonds, which have been around really only since the late 1990s, and there’s risk premium in that, so that’s not a perfect, measure of, of inflation either, looking at inflation break-evens, but I’m curious. What sorts of data were you paying attention to in your 14-year governorship? What were you paying attention to make sure that you knew that inflation expectations were being better anchored by the inflation targeting machine?

Don Brash: You’re stretching my memory a bit here, Jon. I can’t remember exactly what particular indicators you watched carefully, but we did have some indicators of inflation expectations, both short-term and medium-term, which we were influenced by, but I guess To a large extent, we were focused on what the inflation outcomes actually were, because those played a very important role in conditioning expectations. And, I mean, I… when this tag was first introduced, and we had monetary policy very tight. Interest rates very high, unemployment going much higher than it had been since the 1930s. It reached a peak of 11%. One of the tasks I had was convincing the unions, particularly that I was indifferent to the unemployment rate. My focus was on inflation. If they wanted to get the unemployment rate down, they had to ensure that wage and salary demands were consistent with that inflation rate. Because otherwise, unemployment would stay high. So, we actually had a… had a major discussion with the head of the Council of Trade Unions in New Zealand, And he understood that if, wage demands and inflation started being more consistent with the target. Then, monetary policy pressure would reduce. And to my astonishment, and many others’ astonishment too, and to his great credit, he went around the countryside talking to trade unions, saying, guys, if you want to get interest rates down, monetary policy pressure reduced. then you’ve got to moderate your wage demands. And it was sort of self-reinforcing.

Jon Hartley: That’s, that’s fascinating. I’m curious, like, you know, one thing, I guess, that makes… the Fed, the Federal Reserve, so different from other central banks around the world, I think some people may not realize, is that it’s very… the Fed is very unique in that it has a dual mandate, that is… I mean, some people say there’s a triple mandate and stable interest rates, but, you know, the core sort of dual mandate concept that’s been enshrined in law since the Humphrey-Hawkins Act, which is an act passed in the 1970s. basically, you know, price stability, you know, think stable inflation, low and stable inflation, and, you know, full employment, you know, unemployment rate that’s close to, so-called, you know, full employment, or, you know, unemployment that’s low. I’m curious, like, as a cent… when you’re leaning a central bank. that only has a mono-mandate that is to, target inflation. I mean, does… you know, these sort of other unemployment, full employment concerns ever come, you know, front of mind? You know, for example, you know, I guess we had the, you know, the Great Recession. My sense is that some of these mono, mandate central banks, like the Bank of Canada, is kind of focused on, and kind of may even have some sort of… unspoken of dual mandate, but I guess there’s also this thing that economists call the divine coincidence, where you can kind of target inflation and end up sort of targeting both, inflation and low, stable inflation, low inflation, and stable unemployment as well. I’m curious what you… what you think about that, or what are the things that, I guess, as a mono-mandate central bank, or those challenges, you know, as you mentioned, speaking with the trade unionists, how does that sort of come about? I mean, I think during your tenure, it was a pretty stable time. macroeconomic-wise, but I, you know, I think about, you know, 2008, where, you know, central banks, really kind of went all out to, and since in 2020, even further, you know, more central banks are engaging in quantitative easing, doing other things to keep interest rates. low for the express purpose of really trying to simulate the economy, revive economic growth, and bring down unemployment. I’m curious how that sort of thinking kind of works?

Don Brash: Well, I mean, I’m trying to recall the name of the well-known economist, I should note offhand. Who says you cannot have more than one goal per instrument. And I think that’s now widely accepted, and I suspect Alan Greenspan and the Fed guys would accept that, too. They go through the pretense of having a dual mandate, because that’s what the law requires of them. For a brief period, the New Zealand Labour Government, just a few years ago, introduced a dual mandate for the Reserve Bank of New Zealand, because the Fed does it, the Reserve Bank of Australia does it, so we should too. Now, we’ve reverted to a single mandate, where inflation control is the only objective of monetary policy. Now, of course, frequently, the twin objectives will be consistent with the same policy. If unemployment is very low, chances are that your inflation rate will be pushing towards the top of your target. And vice versa. But if unemployment’s going up. and inflation rate is too high, then you’ve got no choice but to make a choice between those two objectives. And there’s no doubt at all that in our case, our primary objective, as indeed our… formerly our only objective, is controlling inflation. So, we reject the logic of the dual mandate. We think the dual mandate is a fiction, which fetus to go along with, because that’s what the law says, but, yeah.

Jon Hartley: Well, that’s fascinating. I’m curious to get, some further thoughts on some of your own, you know, thinking on, you know, monetarism, and… I know you crossed paths with Milton Friedman, who was a Hoover Senior Research Fellow, one of the most famous economists of the 20th century, and, a pioneer of monetarism and free markets in general. I know you crossed paths with him several times. I’m curious. What your interactions with him were like, and when these interactions took place?

Don Brash: Yes, I mean, it’s a curious contact. My first contact with Milton Friedman was very odd. I was running this investment bank, as I mentioned to you, in the 70s. And one of my competitors, a close personal friend, was running a competing investment bank. And he brought to New Zealand some American economist, I can’t recall who it was now. And, it got some media coverage, and I said, how can I upstage my friend? I thought, the best way I’m getting… bring this THE best American economist, namely Milton Friedman, and everyone knew who he was, and his status was fantastic. A very long shot, but I’ll try to see if he’ll come to New Zealand. And, invited him. By good fortune, he said, I’m coming to Australia later in the year, happy to come across to New Zealand with my wife, Rose. No fee required, as long as you show me around the South Island for a week. with my wife, which is what we did. We traveled that part of New Zealand, the more scenic places, and he gave 3 major speeches in New Zealand, our main… 3 main cities. And that began a good friendship with Milton and Rose. Subsequently, I had a meal at their home in San Francisco on several occasions. And we talked about it. He visited New Zealand later. In fact, not long before they both died. They visited New Zealand on a cruise ship. And when they were in Auckland, the main city of New Zealand, my wife and I hosted them to dinner at our home. I think they were both 93 at the time, and I’ve just enormous admiration for him, and indeed for Rose, both, of course, as an economist, but also as people.

Jon Hartley: That’s, so fascinating, and it’s amazing, I mean, seeing their influence around the world is, you know, I think military truly is, you know, undeniably, you know, perhaps alongside Keynes, the most influential comes the 21st century. or, sorry, the 20th century. We’ll, you know, we’ll see about the 21st century as it plays out. I’m curious, you know, you, you know, took the helm of the Central Bank of Reserve Bank of New Zealand in the late 1980s, and I’m curious, you know, again, you know, the Fed at the time was very focused on targeting monetary aggregates. Was this something, you know, following money, was that something that the Reserve Bank of New Zealand was doing a lot of? You know, was it already focused on using interest rates as a policy tool, like how most central banks use them today? I mean, if you look at a lot of central bank discourse today, and macroeconomic research, you know, the whole concept of money is largely absent. And I think part of why the Fed abandoned targeting monetary aggregates was that money demand wasn’t very predictable. There’s questions about what is money, and this, you know, does Treasury bills count and things like that, but I’m curious, back in the 1980s, when, you know, Milton Friedman and some of his thinking was, I think, at his peak. at the Versus Bank of New Zealand, was money something that was often talked about, or at least sort of used as a reference point in predicting inflation? I’m curious, how do you think about money and monetarism?

Don Brash: Short answer is we did not pay much attention to money aggregates, and that was partly because following this 5- or 6 year period of extraordinary economic policy change, we didn’t find anything very consistent or predictable in the money overgrids, so we didn’t spend much time watching them. In fact, we had a sort of some arcane monetary policy framework. I’m not sure that I’ll bore you with the details of it, but it was quite unlike any other policy anywhere else in the world, as far as I know. But we focused very heavily on convincing the public we were serious. And we kept tightening monetary policy when inflation was out of the… out of the target. Now, when you say tighten monetary policy. What we did was… We had an absolutely minuscule lever. But for some reason, they had a big effect. We targeted the aggregate of balances with the central bank, which the whole banking system had, There had to be… this… numerical aggregate in the banking system’s collective accounts with the central bank, every night. And we kept that number very low when we wanted the policy to be tight. But the amazing thing was. we hardly ever had to change it. We just had to imply that we might. We would sort of clear our throat and say, inflation’s not quite where it should be, and almost instantaneously. interest rates all over the economy would go up and vice versa. It was a… it was an odd framework in terms of implementation, but it… but it certainly worked. In the mid-90s, we followed the Bank of Canada Which, you may recall, had a monetary conditions index. which was a mix of… of interest rates and exchange rate, both of which in a small economy, of course, have big effects on… on… on the… of the measured inflation rate. We made the mistake of publishing that index. At that time, the Bank of Canada had not done so. And we also made the mistake we didn’t have it calibrated correctly. So within 18 months or 2 years, we abandoned it. It was just accredited in the market, and it’s regarded as one of our mistakes. As I say, I think the problem was we didn’t have it calibrated correctly. But in a small economy, both the exchange rate and interest rates have an effect On… on inflation, both, both as… as measured and, and, longer-term, more deeply-seated factors. And of course, in 1999, We adopted a more conventional implementation regime, where we set a cash rate Which we pay on balances with the central bank. And raise and lower that as required.

Jon Hartley: Interesting. So there’s… now, since the 1990s, there’s been a policy rate that’s sort of a lower floor on interest rates. That’s fascinating. Prior to that, I guess the central bank would do open market operations to try and name.

Don Brash: Oh, yeah.

Jon Hartley: These various rates and exchange rates and so forth.

Don Brash: Yep.

Jon Hartley: That’s fascinating. Yeah, it’s amazing how… and then now, you know, fast forward post-2008 in the U.S, and post-2020 in an ample reserves regime, where, you know, you have… you know, the money supply curve’s moved so much to the right that, you now sort of have to use, these sorts of policy rates as a floor and have these, you know, sorts of corridor systems in the U.S, like you’ve got. The reverse repo system (ON RRP) is sort of the lower Band, and then you’ve got, interest on excess reserves on the higher end, and you kind of need to pay interest on reserves in order to even move these interest rates around. So it’s interesting how just the policy tool regime has changed over the years, and it’s really fascinating to see how that’s evolved. I’m curious, I guess we talked a little bit about this before, but I’m curious about your thoughts about the state of central bank independence. Today, you know, and how it evolved in the late 80s, you know, and how it’s evolved since, you know, I think one thing people don’t really realize is how how recent I think central bank independence is, as a concept. And even Milton Freeman wasn’t really, I think, you know, there’s not maybe a perfectly accepted definition of what central bank independence means. But, you know, I think Milan Freeman was, at some level, a bit of a critic of independence, in that he kind of argued that, you know, in the U.S, like, the president kind of gets the monetary policy they want, because they’re the one making the appointments. But he also sort of argued for, you know, a central bank money growth target, sort of to remove the politicians from it, in a sense, I guess, if it could somehow be written in the Constitution or something like that. I’m just curious, you know, some central banks around the world, you know, have these five… I think a lot of them now have these five-year framework reviews. In particular, in Canada, you know, it’s sort of a back and forth between the Ministry of Finance and the central bank. Within the U.S. at the Fed, it’s very much internal. That is, you know, the U.S. Treasury doesn’t get to have a say in terms of what The Fed’s, you know, framework review should be, there’s been a lot of controversy in the U.S. about the 2020 flexible average inflation target regime that the Fed adopted right before inflation spiked, and the idea was, you know, that inflation had run so low in the 2010s that they should try and make up for it, you know, having some sort of averaging wasn’t clear about how long they would average over and so forth, but I’m curious, like, do you think that this model of, having sort of, input on, these, framework reviews from, you know, between both the central bank and the Ministry of Finance. Do you think that’s optimal?

Don Brash: Well, I mean, you’ve got a very different situation in the US, where clearly the fear, at least notionally, is fully independent of the Treasury and the administration and so on, even though the president does get to appoint the federal governors, and the chairman, I think, from memory too, is he appointed the chairman? I think he… does he?

Jon Hartley: He does. The president gets to appoint, essentially, you know, the entire Federal Reserve board. They don’t get to, appoint… the president doesn’t get to appoint the regional, Fed, presidents.

Don Brash: Bye.

Jon Hartley: the Fed Board, still has sort of some veto power over those.

Don Brash: Right.

Jon Hartley: a presence.

Don Brash: Right. I must say, I prefer the New Zealand framework to any other framework anywhere. I mean, it’s adopted, of course, as I said earlier, by Australia, by Canada, by Sweden, by UK. It puts the responsibility where it should lie. The government of the day has, and should have, the decision about how fast their currency devalues. That’s a political judgment. But the delivery of that, and they must be forced to tell the public what that depreciation of the currency is going to be. If I’m going to depreciate my… if I’m the Prime Minister, I want my currency to depreciate fast, I should tell the public so they can adjust their decisions in the light of that… that information. But once that’s decided, the central bank should be free to run monetary policy as they judge appropriate. In order to deliver that target. And overtime them if they don’t? That seems to me, in a democracy, the right framework The situation in the US, I think, is, in terms of monetary policy, a terrible one, when the president clearly is unhappy with interest rates. But if the Fed reduces interest rates and inflation takes off. he’ll be the first to brain the Fed for higher inflation. I mean, it’s… it’s… It’s not a good situation.

Jon Hartley: Well, I mean, it’s fascinating how, I think you mentioned earlier about how the Reserve Bank New Zealand’s sort of original framework, if I understand it correctly, was that if the inflation target had sort of got outside its bound, then that was kind of a fireable offense.

Don Brash: That’s correct. That’s correct. And, I mean, the first time we went outside the bounds was caused by the first Gulf War. caused a spike in international oil prices. The measured CPI went above the range. The board had responsibility to write to the Minister saying, notwithstanding the fact that this is outside your target. We recommend you don’t fire the governor because these exogenous factors have caused this… this spike. The interaction between fiscal and monetary also comes into play in the 1996 period, when the government was very keen to reduce tax rates. The Minister of Finance wrote to me as Governor, saying, if we cut tax rates by X, Would it require dramatic tightening of monetary policy? Because clearly, fiscal and monetary policy interact with the inflation rate. And the framework recognizes that interaction. If the government wants Easy monetary policy, and a given inflation rate, they might well have to do something with fiscal policy.

Jon Hartley: That’s fascinating, and I mean, today, you know, the fiscal monetary interactions certainly get a lot of discussion, given, you know, the quantitative easing that’s going on, you know, central banks going out and buying long-term government bonds. And then you also, in the U.S, you’ve had some pretty big shifts in debt management policy. Here in the U.S, the U.S. Treasury decides what the maturity of the newly issued debt’s going to be. And, Obviously, you know, that decision upon, you know, the finance ministry to issue more or less long-term debt is basically isomorphic or equivalent to the central bank buying or buying or selling more long-term bonds. So, you know, quantitative easing, quantitative, tightening, you know, can very much be offset by issuance policy from the Finance Ministry of the U.S. Treasury. So, I mean, it’s so interesting how these things are very much connected, and absolutely, you know, accommodative or tight fiscal policy, you know, can be moving in the opposite direction as monetary policy. I mean, it’s fascinating how the you know, the frameworks of the Reserve Bank of New Zealand, I mean, in some respects. Some people might say that, you know, that there’s less independence, in that respect, for the central banks, but at some level, you know, there’s also, maybe this is a good thing in the sense that there’s more coordination around these sorts of policies and in going after, you know, stable inflation. I’m curious, I want to pivot a little bit toward, because you served as opposition leader, you were an MP for many years, and leader of the National Party. I’m curious, you know, what you think about New Zealand from a cost of living zoning, you know, trade policy standpoint, I’m just curious, you know, I’ve heard a lot of things about land use regulations in New Zealand and places like Auckland and Wellington making It’s very unaffordable there. I think New Zealand has had a housing sort of, affordability crisis in the same respect that Canada has had one with land use regulations, and the U.S. has had one, largely in its coastal real estate markets. I’m curious what you’re thinking around that, as well as sort of New Zealand’s role in international trade. Obviously, it’s much closer to China and Australia, and those are big trading partners for New Zealand. I’m curious. What your take is on New Zealand, where it’s at today, as an open economy, and how some of these cost-of-living issues that are common around the rest of the world, how they manifest themselves in New Zealand?

Don Brash: Well, the land use regulations you refer to has been a major headache in New Zealand. We’ve had tight land controls around our major cities. And the consequence has been exactly as you found them in the United States. Places like Portland, Oregon, Seattle, San Francisco, New York, etc, which have similarly tight controls, have similarly outrageously expensive housing. Successive governments have said, we’ll fix the housing crisis, and successive governments have failed to do that, but the current government is actually making some progress. And whereas in Auckland. the ratio of the median house price to the median household income was about 11 a few years back. It’s now down to about 8.5. So it’s come back quite a bit, and the government seems intent Gradually, on deflating that bubble. I’m strongly in favor of what they’re doing in that area. Where they can get away with it politically is another question, of course, because more people own houses than don’t, and people don’t like seeing their major asset decline in value. But that it needs to decline of value is beyond doubt. And, as I say, the government… current government’s making some… some modest progress in that regard.

Jon Hartley: Huge political economy problem, you know, just…

Don Brash: It is, I’m…

Jon Hartley: like entitlements in the U.S. as well, you know, people don’t want to lose their benefits or their home values.

Don Brash: Yep, exactly right. And, I mean, for us, the model housing market, I think, not sure if it still is, but Houston was the model we looked at and said, my gosh, they’ve got house prices which are a very modest multiple of household income. And they’ve clearly got it right, and of course, as you well know, in Houston, there are no land restrictions at all. You can build whatever you like. And that’s got some appeal. We are a country of 5 million people, roughly, on an area somewhat larger than the UK, an area, so we’re not short of land. There are all kinds of arguments about good land and bad land and what have you, but fundamentally, our house prices have been outrageously high. We have a fiscal problem, which is not unlike that in most other developed countries. It’s better than some. Our current government debt-to-GDP ratio is about 40%. Which is a long way, short of where the US and Britain and France and Germany and Japan are, but it’s… it’s not good for… and for the same reason. Our populations are aging, and we have, have, Social Security and health expenditure, which is projected to rise. strongly as the population continues to age, and again, in a democracy, it’s very, very hard to change those lines. So we’ve got problems that are very similar to other countries. Additional problem, you alluded to in the trade pattern. I was giving a speech in the Oxford Union just a couple of weeks ago, earlier in the month, and in the 1950, two-thirds of New Zealand’s exports went to the United Kingdom. In 1970, it was 35%, as the common market was looming. Currently, Britain takes 2.6% of our exports. China takes 26%, which is exactly 10 times as much. Australia’s our second biggest trading partner, the US is our third, and of course, we have to live with the administration’s tariff policies, which affect everybody, you know.

Jon Hartley: Well, I’m curious about, I guess, it’s fascinating about, Auckland’s zoning reforms and how successful that’s been. I know Minneapolis is trying to do something similar in the U.S. or has been in, in Houston, you know, which doesn’t really have any zoning, is, I think, a model for, for many in terms of what, what land use deregulation can achieve in terms of affordability. I’m curious, I guess just in general about market reforms, and you came into policy and politics At a time of, a wave of market reforms across many countries in the 1980s, and, you know, what is a market reform, I would say, is just… you know, a general appreciation of economic freedom in policy, in, in laws, in economic policy, laws, in, in general, this manifests itself, I think, in many ways from, you know, deregulation, you know, think in the U.S, deregulating the airlines. You know, thinking about, you know, other industries. You know, in the 70s and 80s, there were many nationalized industries in many countries, and now we, you know, see leaders like, you know, Javier Millay, who’s, you know, going to Argentina, which, you know, suffered under Peronism for many, many decades. And it’s sort of beginning that process now of doing, I think, a lot of the things that countries in the 1970s and 80s were doing, which is, you know, liberalizing their economies, you know, taking certain industries and deregulating them. So, you know, there’s… Whether it’s beef export controls that are being lifted, or, rent controls that are being lifted. You know, I think Javier Milei is this sort of new example of many of the things that were going on in the 1980s, including New Zealand. I’m just curious, like, in your mind, are market reform something that countries, need to sort of relearn? It’s, it’s… economic growth has fallen, especially amongst advanced economies. You know, is economic freedom a viable economic growth strategy? Liberal economic institutions, in your mind, do countries need to relearn this?

Don Brash: Some do, including New Zealand, though to be fair, as you mentioned, we had big liberalization in the 80s under this Labour government, surprisingly. We had extensive import controls. We didn’t have export controls, we had export subsidies for the sheep industry in particular. Tariffs were high, quantitative controls were high, rent controls, you name it, controls we had. All of those went, all the import control… quantitative controls went, tariffs were reduced drastically. And of course, That’s a traumatic thing, as you will understand, when you do it suddenly. Industries which have grown up after 2 or 3 or 4 decades with high protection suddenly find themselves without protection. In our case, the motor vehicle industry was the best example. We had 10 different international companies producing cars in New Zealand for a total market of 100,000 cars. It was utterly ludicrous. They were essentially importing packs of cars and assembling them in New Zealand. There’s no great skill involved in that, but it employed tens of thousands of people. And of course, when you suddenly remove that protection, the adjustment process is pretty brutal. And sadly, that period is regarded by many people in New Zealand as a disaster. As an economist, I regard it as fantastic liberation, and set the economy on a much, much better track than it would have been had we stuck with that dopey framework. It was crazy on tariff policy, on regulations, on you name it. One of the things it did, which was in some ways, might be regarded as counter to that. We introduced, I think, the first framework for… Controlling the fishing industry. I think it’s now been copied quite widely, but clearly, fishing in the open ocean is one where you have the problem of the commons. Anything I grab, you can’t grab if I’m there first. And… and we introduced a system of tradable tradable, what do they call it? Individually tradable… quotas, yeah. So you have… you’re allowed to take 4% of the estimated sustainable catch of a particular variety of fish, or 10%, or whatever your quota is, and it’s a tradable… it’s a tradable right. And…

Jon Hartley: Like a cap-and-trade kind of thing, I guess, with some of these environmental emissions policies.

Don Brash: And I think we were the first to do it in the case of fishing. But it’s been copied now quite widely, and it’s a good framework. So, yeah, I mean… Should we be doing more liberalization in New Zealand? Almost certainly. The government still owns, or part-owns, things they shouldn’t own. Privatization has been a sort of a political hot balloon… hot, hot, yeah, hot topic. But it’s… it’s a vast improvement of where it was, some decades ago.

Jon Hartley: Well, that’s, fascinating, and, we’ll see how long, you know, how, or what, Javier Milei’s impact, will be. I think he’s only 2 years into, into his office as president, and… He’s, you know, just won, another mandate with, with the congressional elections there, and, you know, he’s, he’s… moving from one sort of industry to another, in one policy area to another very quickly, and I think he’s undergoing some labor market reforms and fiscal reforms now, and we’ll see. You know, it takes time. sometimes these things, if done very suddenly, you know, you can end up in a lot of hot water politically. Maybe, perhaps, you know, Liz Truss being sort of an example of that, but it’s fascinating to see politicians attempting market reforms again, where I think for a long time, certainly after the global financial crisis. that, these things, the free markets were, I think. perhaps unfairly getting a bit of a bad rap, and I think understanding the history of market reforms in places like New Zealand and many, many countries that engaged in market reforms in the 1970s, 1980s, I think is valuable. today. A real honor to have you on, Don, and to hear about your pioneering career in inflation targeting and ideas. I think it’s safe to say that alongside fellow New Zealand economist Bill Phillips, you know, the namesake of the Phillips Curve. that you’re both, I think, two of the most famous economists in New Zealand history. It’s truly wonderful to get the full history of inflation targeting, how we got, you know, 0% to 2%, and how you implemented it, and how the Reserve Bank of New Zealand has been working up until today. It’s really an honor. Thank you so much for joining us.

Don Brash: Thank you, John, I’ve enjoyed it. Thank you.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with David, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom, the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is David Henderson, who is a research fellow at the Hoover Institution, and an emeritus Professor of economics at the Naval Postgraduate School.He’s also an editor of the Encyclopedia of Economics. Welcome, David.

David R. Henderson: Thanks, Jon.

Jon Hartley: So great to have you on, and really want to talk about your amazing career, in economics and in communicating economics to the public, which I think you do so well. I want to start with where you grew up. Like me, you grew up in Canada, you grew up in Manitoba, Canada.

David R. Henderson: Yeah.

Jon Hartley: How did you first get interested in economics and make your way to study at UCLA with Harold Demsetz, who’s, you know, a legendary figure in study of property rights, the Nirvana approach? Tell us more about your early life and how you got interested in economics.

David R. Henderson: Okay, so like you, I grew up in Canada. I grew up in two small towns in Canada that you’ve never heard of, and I went to the University of Winnipeg. I started when I was 16, because I’d skipped a grade, and my birthday’s in November, so I was about a year and a half ahead of most people. And it was a 3-year degree in Canada, and there’s a reason that matters. I was a math major, and I was really good at it. I ended up winning the gold medal in math at the University of Winnipeg at graduation. Math didn’t grab me, though, in any really fundamental way. And so what… anyway, my first year, I read The Fountainhead by Ayn Rand. And it just… I was obnoxious for 6 months, you know? Kind of thinking you should be self-interested about everything, and my mother wants me to go get milk for her, and I say, that’s altruistic, you know? But anyway, I got past that. And started reading more of what she was recommending, people like Ludwig von Mises, and so on. So I… while I was doing math part of the day, I was educating myself in other parts, reading Henry Hazlitt, Economics in One Lesson. And I started feeling comfortable enough with the economic reasoning that I got in arguments with my calculus professor, my favorite professor there, who was a British socialist. And I remember one time. I kind of backed him into a corner, pleasantly, but he said to me, David. You won this argument. But I’m an econ… I’m a calculus professor. why don’t you go to the economics department and see how they handle your arguments? And I thought, you know, you’re absolutely right. Now, this happened in my second year, and as I said, it’s a three-year degree, so I didn’t start an economics course until my third year. And at University of Winnipeg, it was the whole year, you did one course starting in the fall, and writing your exam in May. And I knew halfway through. That whatever I wanted to be in life, it was not an economist, because it was so boring. We learned the Keynesian Cross model, we learned about perfect competition, where everyone produces the same thing, no advertising, no differentiation, it just sounded… perfect competition sounded boring to me. And then my libertarian club that I joined. had… we used our whole annual budget on hiring someone from the University of Chicago. We tried to get Milton Friedman, we couldn’t afford him, and we were recommended to try Harold Demsetz. And he gave 3 talks in 2 days. And it just opened my eyes to what you could do with economics and be at a good school, namely University of Chicago. So he had one talk in which he talked about how property rights can help solve the problem of pollution. he talked about how free markets raise the cost of discriminating on racial grounds, making it expensive to discriminate, and therefore causing less of it than if you don’t have free markets. And this was just so exciting to me. And I calculated, I must have spent between 10 and 15 hours with him, both in the talks, at lunches, driving him to the airport, and we drove him to the Winnipeg Airport. And he turned to me and said, you ought to come to Chicago and get a PhD in economics or business. And with my typical Canadian humility, which wasn’t put on, I said, I don’t know if I’m good enough. And he said, you’re good enough. And what I learned later was that if you didn’t think… if he didn’t think you were good enough, he said that too, I heard from other people. So anyway, That’s what got me, kind of, in that direction. I went down to visit him. two weeks after graduating in May of 1970, he recommended that I get all the past issues of the Journal of Law and Economics, so I did. And I was gonna start at the University of Western Ontario in the fall of 1970. Because that was recommended to me as the best kind of undergraduate program. I wasn’t going to get a degree, just a year of advanced undergrad courses, and maybe a grad course or two. And, Then something pretty awful happened that summer. My brother was 22, I was 19, and he committed suicide. And I didn’t want to go anywhere. I just wanted to stay around my friends, so I contacted the University of Western Ontario, explained the situation, could I come down a year later, and since they weren’t giving me money or anything, that was fine. And then I spent from 8 to 12, every morning. working my way through back issues of the Journal of Law and Economics, and that was just eye-opening. And every time I read an article by someone I thought was really good, I wrote the person’s name. and where the person was. And 5 coli… universities kept coming up. Chicago, UCLA, Duke University of Virginia, and VPI, which is now Virginia Tech. I applied at all of them, God accepted all of them. And, UCLA gave me the best offer. So, I ended up going to UCLA. By then, Demsetz had moved to UCLA. Anyway, that’s how I got into it.

Jon Hartley: Wow. And, Armen Alchian, was there at that time.

David R. Henderson: Yeah, and I kept writing his name down, so when I was in my second year. at the University of Winnipeg, I read this article he’d written called “The Economic and Social Impact of Free Tuition”, and it was just so beautiful, just such good reasoning, and he laid out how, the idea of subsidizing people to college… to go to college doesn’t make sense when the fact that they can go to college means they’re already kind of going to be in the upper rungs of the income distribution. And his analogy was, if an oil… if someone’s sitting on a patch of oil. and doesn’t have the money to drill, you don’t give him the money. At worst, you lend him the money, because he’s gonna be a wealthy guy once he drills. So your brain is like the patch of oil. And I… and so there was this… There was this commission to look into what they should do about university financing. And I just wrote it out, not even using a typewriter, just wrote out that argument, quoting him, also putting it in my own words, and submitting to this committee why they should be charging us higher tuition and not subsidizing us. So that was my first attempt to kind of lay out some economic reasoning.

Jon Hartley: Well, that’s fascinating. I know… at some level of UCLA has been, in many respects, a home for many Chicago School economists. At one point, I think they were calling it “Chicago West”.

David R. Henderson: Yes, Chicago West. When Sam Peltzman, who I went to visit when I first got there, because I… he was there last year before he went back to Chicago, he had a bumper sticker on his door, the University of Chicago at Los Angeles.

Jon Hartley: Oh, that’s great. That’s so funny. Yeah.

David R. Henderson: Yeah.

Jon Hartley: Well, I know many other, legends of… economics legends have been through there as well. Certainly, you know, Hoover’s, very own, John Cogan, as well as, now past John Raisian and, and Eddie Lazear. Eddie Lazear, attended as an undergrad, and, John Raisian and John Cogan were there for their PhDs. Many Hoover luminaries have been through UCLA as well. well. So I’m just curious, what… if you could define, like, you know. what, did they mean? You know, what were the ideas about property rights that folks like Harold Demsetz and Armen Alchian were coming up with. Explain, like, what exactly, you know, is the Nirvana Approach coined by Demsetz, and what exactly does that mean?

David R. Henderson: I’ll start with Alchian, and then go to Demsetz. So, the way I once summarized Alchian’s work is, you tell me the rules, and I will predict behavior. And so, you know, you tell me the particular property rights regime or absence of property rights, and I will predict behavior. And one of the things that was so great about Alchian is that… you know, the profession had become pretty mathematical by then. I went there in 72. And he didn’t do that. He could do math, he was good at it, but he thought you could be rigorous with words. And I learned that when he graded me, how I would just use words very loosely, and he would kind of write in the margin, no, that’s, you know, you don’t want to minimize this and maximize that, because you can’t do those at the same time. You know, stuff like… and so he just… that was just a great thing to learn from him. Demsetz was along the same lines. Demsetz wrote a piece in the AER Papers and Proceedings. It would never be published now, called “Towards a Theory of Property Rights”, and it’s one of the most read articles in the AER. And… you know, it’s just all about how, in Canada. when the various Indian tribes were catching beaver, and they didn’t, you know, they want to make sure they didn’t… someone didn’t encroach on them, and they had a kind of property rights set up. So he did all of that stuff. Also, there was this book on the UCLA economics school that I did with a fellow economics… a fellow graduate student at UCLA. And it was published by Fraser Institute. And I pointed out that if you look at the timing of this article he wrote, where he talked about what happens when you have things in common, it preceded by a year. the famous article, Tragedy of the Commons, by Garrett Hardin. It’s the most read article in Science Magazine ever, and and so anyway, he beat him by a year, but he didn’t come up with that term. So it’s just those kinds of insights that… and so Demp says it’s the same thing. You tell me the rules, you tell me the property rights, and I will start predicting behavior.

Jon Hartley: That’s fascinating. I know that this was sort of also a big, really critical to what I would say is the, you know, founding of new institutional economics. which, you know, folks like Daron Acemoglu and others are, I think, part of, and just arguing, you know, how much property rights, having good property rights, is essential for economic growth. And it’s interesting, you know, how many others, I guess, have gone through UCLA over the years, whether it’s, you know, Jerry Jordan, who became president of the Cleveland Fed. I think, Bill Sharpe, you know, the Sharpe ratio, he, he went through, UCLA…

David R. Henderson: Mr. Williams got his PhD a couple years ahead of me. We didn’t overlap. He left just, you know, months before I got there. So yeah, there were a lot of… a lot of heavy hitters. Could I get into the Demsetz and the Nirvana.

Jon Hartley: Absolutely.

David R. Henderson: So he wrote an article in the Journal of Law and Economics called “Information and Efficiency: Another Viewpoint”, and what it was, was essentially a critique of this piece by Kenneth Arrow, where he basically was saying, you know, Kenneth Arrow was using what he called the Nirvana Approach. You look at problems with the free market, and then you say, therefore we need government, but you don’t examine how government works. So people now call it the Nirvana Fallacy, but it was really the Nirvana approach, and it consisted of three fallacies, according to Demstitz. The grass is greener fallacy, the people could be different fallacy, and the free lunch fallacy. And he laid out how Arrow did all of… committed all of those fallacies in his famous article. So that was… that was huge, and that was one of the ones that we highlighted in our Fraser book on the UCLA school.

Jon Hartley: That’s fascinating. It’s amazing how, at some level, economists have been become so obsessed with market failure, and at some level, kind of forgotten about government failure, and I think at some level, you have to sort of balance those two out, but I think it… in Economics 101 classes, I think very, very few actually teach any concept of government failure, or, you know, what if you overcorrect for these externalities? What kinds of dangers, what if you can’t really measure social marginal cost? What, what happens from the government intervention, that, That’s, maybe overdoing it in response.

David R. Henderson: And what happens if the government officials don’t have the right incentives? And the way I’ve often put it, and this is quite in line with Demsetz, is, okay, you laid out how incentives in the free market can lead to bad results. When I’m not taking account of negative externalities, I over-pollute, etc. You forget to even look At the incentives that government officials have. And so, it’s just like… it’s just basic. You know, George Stigler, who picked up on… he was a colleague of Demsetz’s at Chicago before Demsetz was at UCLA, And George Stigler said, you know, when you’re looking at free markets versus government, it… most peop… most economists are… kind of like the judge in a beauty contest who sees contestant 1, and that’s it, and on that basis, gives the award to contestant 2. In other words, you aren’t even examining the way… the way government works, so that was a big thing with Demp sets.

Jon Hartley: Well, that’s quite something. So, I want to get back to some of your career, and you were a professor at University of Rochester, and you also were part of the Cato Institute very early on. I think a lot of people aren’t…

David R. Henderson: may not realize that the Cato Institute actually started in San Francisco on the West Coast. I mean, tell us about.

Jon Hartley: Some of those, early days, and, and what it was like being an economist. At, you know, at a time that was still before the Reagan Revolution, you know, free markets, you know, wasn’t totally… Something that I’d say was maybe fully embraced by the GOP at that point. I mean, the Nixon presents, you know, saw, you know, a lot of different things, from price controls, to you name it, you know, which is very, very different from. sort of the, I’d say the free market policies of the Reagan administration. I’m curious, what was that time like for you? And you obviously also went to serve in the legendary Reagan CEA that many others had worked in, including Hoover’s very own John Cochrane, as well as Paul Krugman and Larry Summers, and Marty Feldstein was the chair for part of it. As well as, Bill Niskanen. Tell us about, that sort of early career in economic policy for you.

David R. Henderson: Well, I want to start by talking about, how I decided that I wanted to do more popular writing and less academic writing. I was at University of Rochester. And I was doing academic articles and having trouble getting them published, because I was trying to top 5 journals. Shouldn’t have done that, but anyway, I did. And, I remember I was on a call with a friend of mine one day, and I was talking about this article, this academic article I was working on, and then I told him about this piece I’d done on the minimum wage for Libertarian Review. And he said, David, I want to point something out to you. When you talked about your minimum wage article, you sounded like the young, vigorous, excited David I’ve come to know and love. When you talked about your academic work. You sounded like an 80-year-old man who’s about to die. And I sat with that for a week and thought, you know, he’s right. And a friend of mine named Roy Childs, who was editor of Libertarian Review, we were talking on the phone a week or two later, and he said there was an opening at the Cato Institute for a policy analyst, so I applied for it, I got it, I was not a very good bargainer, and that’s a whole story about the wage I… the salary I accepted. But anyway, it got me writing every week. for a general audience. And then I went back to kind of thinking about Alchian. It’s like, how do you write clearly and accurately for a general audience, even to underst… even to explain kind of complicated points? And I got pretty good at that. And so I was writing… I was applying… I was, every once in a while, submitting things to the Wall Street Journal and not even hearing back from them, or hearing back that it was a no. You know, that’s when you sent things in letters, you remember letters? how you sent them. Anyway, But also, I should go back to one other thing, because this is all kind of setting the stage for how we decided to specialize in writing for a general audience. Finis Welch, who was this famous labor economist at UCLA, he’s the one who John Cogan and John Raisian studied under. I didn’t, but I was sitting in his… Labor economics class, and he one day asked us to guess the number of readers, number of… the average number of readers of a journal article in an academic journal. And we started at 100, and worked our way down, and finally the answer was 4. And I went home that night and said, do I want to spend my life writing articles that four people will read? Let’s say I’m 3 times the average quality, so it’s 12. Let’s say it’s a nonlinear relationship, so it’s 30. Like, still. So that was actually when I started submitting articles to the Wall Street Journal when I was a graduate student, and I kept getting rejections. But anyway, that set the stage. So, Reagan gets elected, and there’s a whole story there about… so, okay, when I was… when I was the editor of Policy Analysis, I wrote a, a defense of all these deregulating economists, people like Murray Wiedenbaum. Because the… the Village Voice had a really scurrilous attack on them, and I wrote a… my editorial was titled, “A Reply to the Voice”. And I sent copies to every… every economist who was pushing deregulation, just so they would know someone was defending them. And Murray Wiedenbaum wrote back a nice note. He was like Mr. Deregulation at the time. So one day, I’m driving home, I quit Cato and ended up teaching at Santa Clara University. I’m driving home from Santa Clara to San Francisco. And I find out on the radio that Wiedenbaum’s just been chosen as the chairman. So I get home, I call his office to remind him who I am, because I want to be a senior economist. And, they say he’s gone home for the day, so I just called the St. Louis phone book, 314-555-1212, and got his number at home, called him, and this is funny, it’s funny in a funny kind of way. his wife answered, and I later became kind of friends with her, but she answered, and I said, I heard Marty’s going to be the Chairman of the Council, and she goes, he is? So, he had… he’d accepted without telling her. That’s like… that wouldn’t work in my marriage, but anyway. So, he called me back, and then he said, yeah, he’d be back in touch, and then… they were dealing with the budget and tax policy. He had no time to be back in touch. Meanwhile, Cogan, John Cogan, we talked about, had become Assistant Secretary of Labor, and he hired me to be one of his assistants. That’s how I got closer to Cogan. It’s also how I got closer to John Raisian, who became a very good friend when we… because we knew each other in graduate school, but he was a year ahead of me, and, you know, we didn’t know each other well. Anyway, so I went there, and then once I was there, Wiedenbaum invited me over for an interview for Senior Economist, made me the offer, and I was going to be working under him and Bill Niskanen. Bill Niskanen was one of the members, but then Murray quit in July of… 1982, I was coming in in August, so he and I overlapped for only a few weeks. That was another interesting story. I had left the Labor Department on a Friday. My wife-to-be had moved from Santa Clara, where we’d met. She was an English composition lecturer. And, we’re planning out our next week of vacation before I start that job. And I get a call from Murray, and he says he’s talked to Marty Feldstein, his replacement, and Marty has asked him to invite all the people he’s made offers to not to come. Well, I’d been a summer intern at the Council of Economic Advisors in 1973 under Herb Stein and Nixon, and so I knew the kind of the gentleman’s rules, which is the person making the offer, it’s good no matter who comes in and replaces him. So I said to Murray, could you please tell Marty I respectfully decline his invite? I’m coming. So I got there, and overlapped with Murray for 2 weeks, and then Marty came in. And so, it kind of worked out. Well, that was another thing, like, I… I looked around, and I knew he was bringing in Paul Krugman, he was bringing in Larry Summers, and I thought, well, they’re not health economists. And I looked around, there was no one doing health economics, it seemed to me. And I hadn’t done it, but I’d read a lot of it, and I liked it. So I spent 2 weeks just boning up on health economics to be ready to make my pitch to Marty. And so, I would, you know, I’d… there was a health economist named Joe Newhouse, everyone’s heard of, and I’d read his work, and I’d call him up to ask him a question about it, and he’d take my call, because I’m calling from the Council of Economic Advisors, and I could tell by the way he answered, that was not a dumb question. And so anyway, Marty, the day after Labor Day was his first day, and he had all of us in this little room, maybe these, like, 12, 15 senior economists, junior economists like, John Cochrane and Greg Mankiw. I mean, you know, all these people that turned out to be heavy hitters. And, Marty said, I want you to go around the table and say your name and where you came from. And I thought, you know what, I’m gonna… I’m gonna take a chance here. So, when it got to me, I said, David Henderson, Labor Department, and I’d like to be the health economist. And I see Larry and Paul just kind of whispering and laughing, like, who the hell’s this guy? I go back to my office. An hour later, I get a call. The chairman would like to see you. It was his… it was Marty’s secretary. And I went down there, and marnie says, I hear you’re somewhat of a health economist. And I thought, do not over-promise. I said, well, two weeks’ worth, but I’m a fast learner. And he goes, you got it. So, I was the health economist under.

Jon Hartley: what was it like, I guess, you had people like Paul Krugman, Larry Summers, I mean, I’m sure there were probably others around, maybe Greg Mankiw came later and…

David R. Henderson: Well, he was there as a junior. He was there as a junior, yeah.

Jon Hartley: I mean, was it… clear that these folks were all pretty ascendant, I guess, in macroeconomics at the time, and…

David R. Henderson: Paul Krugman was already known for the work that helped win him the Nobel Prize, which is the monopolistic competition thing. Like, I think it kind of… the way I think he posed the question is, why is it, when we talk about specialization across countries, why is it that Sweden produces cars, and the United States produces cars, and Japan produces cars? Like, what’s this specialization thing? And he had this whole model, and that was… that was part of… And people knew about it, and so… I had a friend who was a fellow UCLA graduate a couple years ahead of me, Ted Freck, who visited me, and we were in the cafeteria, and he looks over, and he sees Paul, and he gives me a nice summary of what Paul had written, you know, and so yeah, and everyone knew Larry was really sharp. Very different personalities, by the way. Like, Paul kind of kept to himself. Larry was… outgoing, if you want to go into his office and talk about something, he was very welcoming in a way that St. Paul wasn’t. But, anyway, so… it was an interesting group. One thing, by the way, Marty and Bill did not get along. And so, the… health economics was fine, that was Marty, but Marty made me an offer to stay a second year, and I wanted to accept because I could always say, no, no, he didn’t just inherit me, he wanted me. So I accepted. And then Ben Zycher, who’d been the energy economist, left. And I… and I asked if I could take on that portfolio, because energy was dialing down. Reagan had done the good thing by adding the price controls, and I felt like I can handle both, and Marty and Bill said yes, and it was on that issue Where I was answering to both of them, and I had to learn how to do that without getting in the middle and getting both of them disliking me, and I think I ended up doing that pretty well.

Jon Hartley: That’s fascinating, and what a time to be there during the Reagan CEA, and…

David R. Henderson: Yeah.

Jon Hartley: You know, through, you know, there are a couple amazing tax reforms, That, you know, brought marginal rates down substantially, and, was the one change to the business tax code, really, in 30 years, and it wasn’t until the Tax Cuts and Jobs Act of, of 2017 that the U.S. was able to cut the corporate tax rate again. I want to just talk a little bit about, you know, your interest in getting into, you know, communicating economics to the public. I know we talked a little bit before about shifting from, you know, writing academic articles, which maybe a few people read, to. you know, writing more, more for the public. I mean, I think you were very early in, you know, communicating, to the public online, and, and, you know, you’ve been involved with. EconLog, you have a Substack now, you have the Concise Encyclopedia of Economics, which you’ve been working on for a long time. I’m curious, you know, what piqued your interest in these various groups, and how did that all start?

David R. Henderson: So, it really started with writing for Fortune. When I was at the Council of Economic Advisors, Ed Meese was a, you know, major figure in the Reagan administration, and he asked either Bill Niskanen or… or Marty, I can’t remember who, as a favor, could… could he kind of assign one of his senior economists for a few hours to help him with this speech he was making, critical of industrial policy? And I thought, yeah, I’m very critical of industrial policy. And when I started researching it, I went, oh my god, like, I’ve learned so much. And one of the big things was what I ended up calling the myth of MITI, that MITI, the Ministry of International Trade and Industry in Japan, didn’t plan the economy that much, and to the extent they tried, they failed. And so I wrote some of these things up for Ed Meese’s office, and I thought, this would be a great article. And meanwhile, I was talking to the Washington Bureau Chief for Fortune. whom I’d met at a conference a few years earlier, and he said, when you get an idea, write up a couple of paragraphs, and I did. He sent it up to New York, and they said, yeah, let’s get David… let’s get Henderson to do this, this piece on it, and they offered me an amount of money I’d never heard of. This is in 1983. They offered me 3 grand. With a 10% kill fee, $300. So, kill fee meaning if they don’t use it, because they don’t know who I am, and a two-week deadline. I thought, don’t bargain about money, bargain about time. So I asked for 3 weeks. And I just kept writing and rewriting and honing. Again, I got the economics, I got the facts, the whole thing was, make this sucker sing. And the first two paragraphs were so powerful, and I… I don’t know, I don’t think I can kind of quote them, but I can kind of… okay. In 1954, a small Japanese electronics firm asked the Ministry of International Trade and Industry, MITI, for permission to buy $25,000 in U.S. dollars in order to buy technology from Western Electric. MITI turned it down. The company tried again. MITI turned it down. The third time, it approved it. They bought the technology, it was the transistor, and the company, Sony, went on to great, you know, great profits, something like that. And so, I said it really well, but I really… and I remember when the fact-checker couldn’t find that. I went, oh my god, there goes my paragraph. So I tracked down the executive at Western Electric, who was way beyond retirement, who had made the deal. And I showed her, no, here’s what he said, and you can call him. And I saved that paragraph. And anyway, so that’s what kind of led me there, and then we were moving out here to the Naval Postgraduate School, and to be able to ever afford a house, I needed to write 4 to 6, book reviews or whatever for Fortune every year. And I made a deal with Dan Seligman, he was a great, great editor, and and so I did that for a few years. And then in 1990, time. Time and Warner merged, became Time Warner, and they wanted to do a joint project, some kind of encyclopedia of economics. And they asked Dan Sullivan, he was very economically literate, very good writer, and he said, I can’t do it. And they said, well, who can? He said, David Henderson. They said, who else? And he said, no one else. So they contacted me, he contacted me to tell me, so by the time the editor at Fortune, a woman named Ann Morrison, called me, I’d had two weeks to really think it out and outline, and when she called me, I just core-dumped. I just told her everything. She goes, well, we’re looking at one other proposal, but I think this is it. And so, anyway, that’s what led to… led to it, and… I got really good people in there. I got Paul Krugman, I got Larry Summers, I got James Tobin, and I wanted it to be mainstream, even if it’s a little bit of a free market kind of tint to it. It’s the kind of things that economists across the board, except sometimes in macro, could agree to. And I think it was very successful in that respect. And then it sold really well for that kind of book, over 10,000 copies, and closer to 15. But that’s not the kind of book Warner Books should have, and so it probably would have sold 30 if it had been the right publisher. Anyway, the rights reverted to me, and then later on, Liberty Fund came along and said. How about… We put it online. And then how about you do a second edition? So we called it the Concise Encyclopedia of Economics first edition, and then the new edition, which was way more work than I expected, was the second edition. So that’s kind of how that worked out.

Jon Hartley: Well, that’s amazing, and, you know, to your credit, I mean, working with, people like Ed… Ed Meese, is… it’s amazing, because he… Really transformed, the conservative legal movement. He, the Reagan DOJ in the OLP, when he was Attorney General, you know, he, was really, began this process of, hiring or appointing, originalist judges, and, I think that was a huge turning point, certainly for the conservative legal movement. And, there’s a great book, a recent book, called The Meese Revolution by Gary Lawson and Steve Calabrese that documents and details all this. But that’s really when the conservative legal movement started to get into gear, and it totally makes sense that he’d be interested in an economist like yourself, helping to write a speech on industrial policy, which again is very timely and, and relevant, again, today. Well, I really want to.

David R. Henderson: Can I add one more thing about that? Because I got going on industrial policy, and I don’t… I’m not… I don’t want to take too much credit, but I do know that there was this discussion of whether we should have a chapter on industrial policy in the 1984 Economic Report of the President, which was the major thing we put out. And I remember arguing strongly for it, and… and we ended up doing it, and I wrote… big hunks of that, of that chapter. Yeah.

Jon Hartley: That’s fascinating. I guess… in terms of arguments against… I mean, industrial policies, obviously, in the news again today, and I’m curious if you have any sort of thoughts. I mean, obviously, many economists are critical of industrial policy, you know, because of these arguments of picking winners and losers. One challenge with some of these arguments is if some sort of, policy case or defense, national security case that trumps, you know, economic concerns. I mean, there was a time when, you know, the U.S. didn’t trade much with the USSR, so why they called the USSR “the Second World”. And, they called Africa and emerging countries the third world. The so-called free world was the first world. They didn’t really trade or communicate between the first world (US and developed allies) and second world (USSR), right? And of course, you know, that might not be in the best interest, but there may be national security concerns why one may want to do that, why one may want to use government subsidies to reshore chips and so forth. But, you know, apart from that, you know, I think at some level, I think for the folks that want to really get on industrial policy, I think one challenge there is, that… I don’t think there’s necessarily, enough ideas that I think people have to even subsidize. Yeah, I mean, at some level, you know, one could make the case that, industry subsidies would be superior to simply just tariffs for… I think that there’s some reasons why one might want to do that, just so you’re not increasing prices on your own, your own population. But, I’m just curious, you know, I’ve always thought that maybe education policy is the best industrial policy or human capital policy, but I’m just curious, what your thoughts are, now, given that industrial policy is, kind of reignited this, the interest of, of, of economic policy people, I’m curious where you stand on these sorts of arguments, and what your… what your favorite arguments are.

David R. Henderson: So… The industrial policy being pushed in the early 80s is a very different… a very different motive from the policy being pushed now. In the early 80s, there was this idea that the government could choose winners, that somehow they could make good decisions, and that’s why the myth of meaty was so important in offsetting that view, that it was a myth. So you had Mondale, who’d made it a major part of his campaign in 1984 against Reagan, and I saw him… I saw Mondale coming, and that’s another reason I was pushing for having this chapter. This is how we can help our president and be saying things that we believe and that are important. So, now it’s more… because… and it wasn’t about national security, not really. Now it’s a different kind of argument, it’s a messier argument that somehow we need to subsidize, as you say, say, computer chips or whatever, in order that we don’t depend on certain supply chains that are… that could be at risk in a conflict. And that’s a messier one, and it’s… I still don’t think the government has really good information, or really good incentives, so I would still argue against that kind of industrial policy, but it’s a different argument. I mean, the argument is the same, but I’m arguing against a different thing.

Jon Hartley: Yeah, absolutely. And that’s, That’s a great historical context to… or comparison to draw. Well, David, I really want to thank you for coming on. It’s a real honor interviewing you, learning about the history of property rights, Harold Demsitz, Arminalk, and their thinking at UCLA, what your journey has been like as an economist, as an academic, as a policy maker, as a communicator. I really want to thank you for coming on. This has been a real honor.

David R. Henderson: Well, you’re welcome. Can I also just push for a minute my substack? DavidRhenderson.substack.com, and I call it, I blog to differ. And anyway, so, it’s been a real riot doing that for about the last year and a half.

Jon Hartley: Well, thanks so much, Dave, for coming on.

David R. Henderson: Thanks.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with George, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom of the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is George Tavlas, an alternate governor of the Bank of Greece for the European Central Bank since 2008. He’s also a Distinguished Visiting Fellow at the Hoover Institution at Sanford University. And he was previously the Director General of the Bank of Greece from 2010 to 2013, and a member of the General Council in the Monetary Policy Council of the Bank of Greece from 2013 to 2020. He was also an advisor to the governors when the country entered the Eurozone, and was involved in the management and resolution of the Greek Debt Crisis. Welcome, George.

George Tavlas: Thank you so much, Jon. It’s a pleasure to be here, and I thank you for the invitation.

Jon Hartley: I want to start by getting into your early life. Where did you grow up, and how did you first get interested in economics?

George Tavlas: I was born in Worcester, Massachusetts, to Greek immigrant parents. My father left Greece and his village in Greece and his formal education when he was 12 years old, and he came to the United States at the end of the First World War. He worked his way up and became a successful business person. He owns several retail stores and rental properties. He learned to read and write in English and read the Wall Street Journal every day. Like many immigrants, he had a simple dream. He wanted to see his children have the education that he never was able to have. And so, when I was 13, he enrolled me into one of the top prep schools in New England. It was located in… it is located in my hometown. It’s called Worcester Academy. But then, tragedy struck. Several weeks before I started my first classes, my dad died unexpectedly of a heart attack. After that, I didn’t take classes, I didn’t take school seriously. And so… My grades at Worcester Academy were terrible. I had to repeat my fir- my junior year. And then I did something that… Perhaps was the first in the history of the school, which is pretty hard to do, because the school was founded in the 1830s. I fielded my junior year a second time around. In fact, my grades the second time around were worse than the first time. Well, that’s summer. after the second junior year, a letter arrived at my home, addressed to my mother. It was from the headmaster of the school, and he advised her that the school board had determined that I wasn’t college material. She should look elsewhere for me to enroll. My mother never saw the letter. I intercepted it, and immediately went to see the headmaster, and I asked him for another chance. He gave it to me. He allowed me to enter my senior year with the provision That my grades have to show immediate immediate improvement. Well, that changed things around. For the first time, a fire was lit under me. I realized that I had to study. My grades went up. I applied to 5 colleges, was admitted into all of them. My family stared me to Babson College. It’s a business college, because it had expected or assumed that I was going to go into the family business. That’s with a letter addressed to my mother. Some years later, when I… on the day that I received my PhD degree. I showed my mother that letter for the first time. At the same time that I showed her my PhD diploma. After I, graduated from Worcester Academy, I attended Babson College, Which is… as I mentioned, a business school in Massachusetts. At Babson in my first year, I took… an economic principles course with Bill Casey. Bill had just graduated from Boston College. We’ve become lifelong friends. The course lit a fire. I knew from the… almost from the first that I wanted to pursue economics for a career. I like the quantification and the logic of economics. the faculty at Babson encouraging me to do my graduate work at New York University. At NYU, three courses were especially important for my future research. Monetary economics, taught by Bill Silber. Bill and I had become lifelong friends. History of Economic Thought and Econometrics. My dissertation combined the first two areas, monetary economics and the history of thought. Upon completing my PhD dissertation in 1977, I was offered a position as a macroeconometric modeler at a newly formed economic analysis team at the State Department. The team was created by Richard Cooper. Cooper, who had been teaching at Yale and subsequently was to teach at Harvard, had become Under Secretary of State in the Potter administration. Richard Cooper was a very famous, very famous international economist who just passed away a few years ago. He was an excellent economist and an excellent writer. Well, the main motivation for the economic analysis team under, under Cooper was to create a group at the State Department that could support the State Department’s positions at interagency meetings. So while I was at State, I learned how to Build and simulate macroeconometric models. While at State, I received an offer from the OECD in Paris to help them build their multi-country macro model. I accepted the offer, and… I took a leave of absence from the State Department in 1980. That turned out to be a good decision professionally. And a great decision, personally. Because while… living in Paris, I was able to visit Greece frequently, because my mother had resettled there, and on one of those visits, I met my future wife, Sophia. After I returned to the State Department, George Schultz had become Secretary of State. Alan Wallace had become his Undersecretary. Wallace had been his former colleague at Chicago. Martin Bailey, who had taught macro at Chicago in the 1970s and 1960s. In 1970s, he was a assistant secretary at the U.S. Treasury, had become the chief economist. Martin was a theoretician. He was a brilliant theoretician. He needed someone to do the estimation to test his ideas, and I was the person to do it. We worked very closely together. We wrote several… published several papers, continued to receive citations. I learned a lot from that… from Martin. In 1985, I received an offer to join the IMF. And I accepted it. At the IMF, I was assigned to do research, among other things, on the international monetary system. One of the things I was especially involved with on… was looking at the advantages and disadvantages of a country having an international currency, such as the U.S. dollar. A very topical issue today in light of the tariffs. However, as I rose through the ranks at the IMF and was promoted to managerial positions, I had less and less time to do research, which I especially enjoyed. And so, having spent several years Visiting the Bank of Greece in the late 1990s, I accepted an offer from the bank to become a director. at the bank, where I was able to continue to do research, while at the same time continue to do policy-relevant work in such areas as the Euro-sovereign debt crisis and, of course, monetary policy. Among the responsibilities that I’ve had at the bank, in 2002, The then governor appointed me as his… then accompanying person, but it’s essentially the same as his alternate on the governing council of the ECB. Now, the way this works, each governor at the ECB is allowed to bring one person with them into the meetings to be able to consult with. The alternate takes the place of the governor, should the governor not be able to attend the meetings. Since… That appointment, successive governors at the Bank of Greece have reappointed me as their alternate on the governing council. So, having served on the governing council as an alternate since 2002, Continuously, I’m the longest serving member of the Governing Council. During the past 10 to 12 years, I’ve had the privilege to be visiting such institutions as Chicago on several occasions. Drexel, Duke, and of course… the Hoover Institution at the invitation of John Taylor. These academic associations have been instrumental in helping me revisit the fierce debates over Milton Freeman’s monetarism in the 1970s when I was a graduate student. They became like a thread of my research over the years, and it’s the reason that I was able to write the book, The Monetarists.

Jon Hartley: That’s terrific. I want to talk about The Monetarists in a moment. I also just want to talk about, a little bit about your career. I mean, you’re there at the dawn of the euro. You’ve seen the… you know, the European debt crisis in the early 2010s play out? What do you think we’ve learned in the past 25 years, since the advent of the euro, about the nature of monetary unions without a fiscal union. And what do you think, the euro will look like in the future. I mean, do you see there being more fiscal integration in the future? Obviously, there’s a lot that’s changing right now in Europe in 2025, with increased military spending and, and… more debt being issued, for example, by Germany to partly fund this, but I’m just curious, having been there at the beginning. having seen some of its… and been part of managing some of its greatest challenges, notably, you know, Greece, the Sovereign debt crisis in the early 2010s, and it’s, you know, been put in a better trajectory. I mean, at the time, there were a lot of questions around whether Greece would leave the euro, or other countries would leave the Euro. That hasn’t happened yet, but there are many critics, I guess, who say that a monetary union without a fiscal union is, isn’t sustainable in the long run, and that encourages, free riding on the part of some countries. I’m just curious what… What you’ve learned and what you think economists have learned about the nature of this monetary union.

George Tavlas: Well, I don’t think that economists have learned a great deal about the need of a fiscal union. They knew that before the euro system started. They thought that the monetary union could survive in the absence of a fiscal union, because they thought that the markets would… Would impose discipline on countries that were spending extravagantly. But it didn’t happen that way. Between 2005 and 2009, Greek government debt doubled from about 100… external debt from about $150 billion to $300 billion. And yet, for much of that time, Greek interest rates were very low. The markets thought that if Greece got into trouble, the euro area would be able to increase. It wouldn’t have let a crisis happen. And so, while the Greek debt was… building, doubling, as I mentioned, in the 5 years 2005 to 2009. Especially during the early years, 2005 and 2006, Greek interest rates were not very much different from German interest rates. So, one lesson that we’ve learned from the Euro is that countries have to maintain their fiscal hosts in order. We’ve also learned that we need to have a stronger fiscal mechanism inherently in Europe, in case countries do get in trouble, where that mechanism can support the countries, perhaps impose policies on the countries to take, should a crisis erupt. Now, when the crisis erupted in Greece in late 2009, … the, the Euro system had to rely on the IMF and the European Union, and it was a little bit… Unorthodox, because having been at the IMF, when the country got into trouble, and the IMF visited the country to see what policies would be needed. The IMF would sit on one side of the table. And the finance ministry and the central banks from the other country would sit on the other side. When a Greek crisis erupted, we had… the Bank of Greece and the Finance Ministry on one side. On the other side, we have the IMF, We have the European Commission, and we had the Central Bank of the Euro area. the ECB. So, in a way, there was an advert… there was a clash between our central bank, which was really the ECB, and the policies that were being formulated to deal with the Greek crisis. In retrospect, the crisis that were taken in Greece were… Very, very contractionary. And it was very difficult for Greece to emerge from the crisis. We needed support. … from the rest of the union, but we didn’t get the support. And so what happened? The markets… of course, perceive this. And they perceive that there’s some other countries on the line that could possibly erupt into crises such as Portugal, … Ireland, and even Spain, which required a program for its baking system. So, one lesson that we learned is that We need to have an internal mechanism within the euro area so we don’t need to rely on the IMF should a crisis erupt. Another thing that we learned was, and… Now, as I mentioned, at the beginning of the euro area, people understood that… We weren’t a complete fiscal union, and that was going to create a problem. But one thing we didn’t anticipate, nobody essentially anticipated, maybe one or two people in, … peripheral journals, because I came across one… one person who argued this in the early 1990s, but nobody paid attention to him. We learned that we needed a banking union. We need… we learned that… If Greek beings got in trouble, the Marxists weren’t going to believe that the Greek government a small country is going to be able to take care of the banks. Now, we had a situation in the U.S, I think it was in 2023, as Silicon Valley Bank got in trouble. You remember that? And, one or two other banks followed suit, and those banks were going under. And it started looking like it could become a full-scale crisis. And so the stock market, financial markets, began to tank. And then one day, within days of the crisis having erupted, Secretary of State, Secretary of Treasury Janet Yellen said. All depositors will be covered in full the next day, or… Around the same time. Jerome Powell said the same thing. Was it Jerome Powell who was… yeah, Jerome Powell said the same thing. We will bail out everybody. End of crisis. We did… we don’t have that in the Eurozone. If the Greek government said in 2012-13, We’ll take care of the Greek beings. Crisis over. Where were they going to get the resources? They didn’t have it. So, we also need a banking union. We also need a capital markets union to further integrate countries, you know, across countries. So there… there are certain priorities or prerequisites for a well-functioning monetary union that we started to build. We’re in the process of building, but we’re not all the way there yet. We’ve learned lessons, we’re applying it, but it’s a slow lesson to come to a complete monetary union. And that’s one reason why, despite the fact that the dollar has been under siege as an international currency over the last year. there’s really no rival to come up and take the dollar’s place. It’s Chinese yuan, the financial markets are very opaque. Investors don’t want to go with the Chinese want. The euro area, We have tried to make the Euro an international currency, but we still lack the mechanisms I just underlined to make the euro such a valid international currency. We’re away, away. some way away from doing that. We’re working on it, it’s moving in that direction. But things are slow. My governor, by the way, had a, … a guest column in The Economist about 2 months ago, Yannis Stournaras, which has pointed out all those issues in a very nice way.

Jon Hartley: Perfect. So, I want to get, into your book, The Monetarists, which you published in 2023 with the University of Chicago Press. And this book essentially argues that on the topic of monetarism, which I think is, you know, broadly speaking, the doctrine that, Inflation is always and everywhere a monetary phenomenon, and that, you know, MV equals PQ, that’s, you know, the quantity, the theory of exchange, or the, quantity theory of money, that, that’s sort of front and center for, for monetary policy, that monetary policy aggregates matter. You know, some people, some monetarists might argue (and were certainly arguing in the 1980s) that monetary aggregates were, a tool, a monetary policy tool that should be used. I think economists have shifted a bit away from that, obviously embracing interest rates. But this was an idea that was largely promoted by Milton Friedman and Anna Schwartz in, I think, the public mind. You know, there was a big book that they released, A Monetary History of the United States, a very famous book, that tries to make the case that the contraction of the money supply caused the Great Depression. And this was published in the 1960s, and a very popular book, and arguably one of Friedman’s most influential books. Now, your book, The Monetarists sort of gets into this, the intellectual history of monetarism, and argues that there was a tradition of monetarism before Milton Friedman and Anna Schwartz, largely at the University of Chicago. And I’m just curious, how did you get into, you know, the debates about Chicago monetarism, and could you explain to us, you know, who some of these earlier Chicago monetarists were, and how they might have influenced Friedman later?

George Tavlas: Well, how did I get into the debate?

Jon Hartley: Yeah, I’m just curious, how did getting into this intellectual history, begin for you, and how did you sort of discover, that the story of Chicago monetarism, begins well before Milton Friedman.

George Tavlas: Well, when I was doing my dissertation in the middle of 1970s. There was a heated controversy underway between Milton Friedman on one side and just about everybody else on the other side. Friedman had been a graduate student and a research assistant at the University of Chicago in the first half of the 1930s. And, when monetarism began to have traction in the late 1950s and early 1960s, he had argued that his monetarist views derived from an important, what he called, oral quantity theory tradition at Chicago. That tradition, he argued, differed from Other versions, what he called rigid versions of the quantity theory, utilized at other institutions, because unlike those other versions, he argued that the Chicago version was policy-relevant. And this policy relevance, he argued, was able to, leave the Chicago quantity theorists less vulnerable to the Keynesian Revolution than quantity theorists at other institutions. He singled out some of his mentors as having developed the Chicago quantity theory. I’ll mention four of them, Henry Simons, Lloyd Mintz, Frank Knight, and Jacob Viner. Now, with the rise of monetarism as a counter-revolutionary force, In the late 1960s, Friedman’s claim of a Chicago monetary tradition came under fire. The first to take game at Friedman was Don Patinkin, who had undertaken his graduate studies and undergraduate studies at Chicago in the 1930s and 1940s. In 1969, writing in the inaugural issue of the Journal of Money, Credit, and Banking. Patinkin presented evidence, doctrinal evidence, from the writings and teachings of his teachers at Chicago, showing that Friedman’s theoretical framework had nothing to do with what had been written about or taught at Chicago. In the late 19… in the 1920s or 1930s. Because Patinken showed that the earliest Chicagoans used Irving Fisher’s, as you mentioned, velocity-based equation of exchange. Money times velocity equals prices times transactions. Whereas Friedman used a money demand approach to his monetary analysis. So, the issue arised that since the two theories were so different, how could they be related? Enter into the picture Harry Johnson, who was Freedman Chicago colleague, not necessarily….

Jon Hartley: International economist.

George Tavlas: Chicago colleague, not necessarily his Chicago friend. who usually… occasion of the 1970 Richard T. Ely Lecture in front of the American Economic Association. To argue that… Well, he made the argument that if… in order to create a successful counter-revolution to the Keynesian Revolution, Friedman had to establish some plausible linkage with pre-Keynesian Orthodox, with what came before the Keynesian Revolution. Friedman’s solution, in Johnson’s words, was to, and this is pretty brutal, to invent a Chicago monetary tradition. In Johnson’s words, Friedman had engaged in scholarly chicanery. In the debate with Patinkin on this issue in the Journal Political Economy in 1972, Friedman admitted that his monetary theory had been influenced by Keynesian theory. But he also continued to insist that his overall monetary economics was what he continued to argue was a direct outgrowth of a unique Chicago quantity theory tradition. He was incensed with both Patinkin and Johnson. He thought that Patinkin had mischaracterized the Chicago monetary tradition, and by doing so, had damaged his Friedman’s professional reputation. In private correspondence, he accused Johnson of having committed libel. And so, while I was a graduate student, I had followed the debate closely, and I decided to write my dissertation on the origins, the doctrinal historical origins of monetarism. I wrote 5 essays. Four had been accepted in journals. The fifth one. dealt directly with the Friedman-Patinkin Exchange and the Journal of Political Economy. I wrote a paper in which I showed that there was Chicago economists in the late 20s, early 30s, who were in favor of policy rules, like Friedman. And not only that, they advocated a Friedman rule before Friedman did. They advocated that the money supply should grow by 3-5% annually. I submitted that paper to the Journal of Political Economy. The editor wrote back that he sent a paper, in his words, to a learned scholar. The learned scholar wrote a lengthy rejection letter. Now. At that time in the 1970s, one of the most popular graduate textbooks was Patinkin’s 1965 Money, Interest, and Prices. I had studied it. read it many times and studied it very hard, and I knew Patinkin’s writing style. I had no doubt that Patinkin was the guy who rejected my paper. So I then submitted the paper to the Journal of Money, Credit, and Banking. The editor wrote back that he sent the paper to an associate editor. The associate editor liked the paper, but he thought that the only two people that were really qualify to judge her were Don Patinkin and Milton Friedman. The editor wrote to me that he… asked Patinkin and Friedman to referee the paper. Patinkin wrote back. That he already refereed and rejected the paper, confirming my suspicion. But Friedman had not responded. The editor said, I leave it up to you. to see if you can get Friedman to respond to your paper. I wrote to Friedman and told him what the circumstances were. He wrote a lengthy letter to the editor. of the JMCB telling him that the paper should be accepted. It was. It was published in 1977. And there began a lengthy correspondence between me and Friedman that lasted until a couple of months before Friedman passed away. That’s how I got involved in the debate about the Chicago Monetary Tradition.

Jon Hartley: That’s fascinating, you know, all these, characters were involved, and, famously, a lot of these iconoclast economists would clash with each other, and I guess it’s… one thing that I guess some don’t realize is that, you know, I guess the Chicago school isn’t necessarily, like, a monolithic, school of economics, and also, you know, it’s very fascinating that, you’re pointing out this, this fact that, you know, the idea for, like, a K% money growth rule, sort of preceded Friedman. I think, you know, the equation of exchange, you know, MV equals PQ goes back to I think David Hume, maybe even earlier. So, you know, I think at some level, there’s sort of different… even different schools of monetarism, in the sense that, like, you know, today there… there’s maybe some people who argue that, I think increasingly following the early 2020s inflation, that… which also saw the money supply, or measures of the money supply, like M2, grow pretty, rapidly during that same time that, we should look back to monetary aggregates, which previously had fallen out of favor. I guess my question,

George Tavlas: Can I… just let me say one thing, Jon. Monetarism is just not money. Money was the vehicle that Friedman thought was important for judging monetary policy. But the lasting contribution of monetarism was to Bring back or highlight the importance of monetary policy itself. In the 1940s, 50s, 60s, even the first half of the 70s, monetary policy was considered a secondary tool. It took a backseat to fiscal policy. What Friedman and monetarism did, didn’t bring back money. That was their way of saying that money was… that monetary policy was important. But what really mattered was monetary policy, whether with money or with interest rates, that monetary policy was one of the most important tools in the macroeconomy. In the 1940s, 50s, and 60s, it was downgraded. It had secondary status. So the monetarist revolution, when some people say, whoa, where’s money? Doesn’t matter. What matters is, look where monetary policy is. It’s right there on top. It’s the… it’s the primary tool for managing the macro economy. When monetary… when… the Federal Reserve or the European Central Bank make a decision on interest rates. Everybody’s following. Everybody reacts. And depending upon the decisions, the reactions could be benign, or they can be They can be very volatile, but monetary policy is right there at the top of the policy list, of the policy Options that we have in the economy. And that is due to monetarism.

Jon Hartley: Absolutely, and… it’s worth noting that, you know, thinking back to the 1970s, I think there was an idea that, you know. Inflation, some people argued that, you know, price controls were the right answer, to fighting inflation. You know, this was, I think, apparent in the Nixon administration.

George Tavlas: And that was Arthur Burns. That was Arthur Burns, who, when he was appointed chair of the Federal Reserve, Friedman was ecstatic because he thought that Burns was somebody who understood monetary policy. But no, Burns relied, as you said, on price and wage controls. He let monetary policy run loose, and we had two episodes, one in the mid-1970s, and one in the mid-1970s, where inflation reached double-digit levels, and it was Paul Volcker. Who came on the scene. And he understood. As well as anybody else, the importance of endogenous expectations. He understood that markets had to have belief in that the Federal Reserve is doing the right thing. Volcker’s approach was to apply cold turkey. Raise interest rates to close to 20%, let the economy go into recession. It had to prove something. It had to prove that the Federal Reserve was what we now call hard-nosed credibility. The Fed gained credibility under Volcker, and it maintained credibility under the success of Fed shares, like Alan Greenspan, and… Bernanke and Yellen, they all understood that credibility is very, very important. And when we had the rise of inflation. In the early 220s, both the ECB and the… and the Fed. may have been a little slow to react, especially the Fed, but the Fed had credibility. Price expectations never took off because the markets had believed that the Fed would take the necessary action to bring inflation back down, and it did. And that’s all the legacy of the… what happened in the late 1970s, early 80s from Volcker.

Jon Hartley: You know, I also tend to think that there’s two schools of monetarism. And, yeah, I think there’s various sub-schools of monetarism, in the sense that there’s… I’d say, a group of, maybe, passive monitors, think Milton Friedman K% Rule that argues you know, the Fed should just be run like a computer, just grow the money supplied by 2% every year. We don’t need FOMC meetings, or we don’t need monetary policy council or committee meetings, and that the central bank’s sole job should be just to maintain price stability, and do so with a constant money percent growth rule. And that’s it. And I would say there’s maybe another school of people who argue that, you know, yes, MV equals PQ matters, but, you know, per Friedman’s observation, you know, monetary policy is not neutral in the short run, and that it can impact real economic variables. And that the Fed or central banks should intervene. During periods of recession, Should provide monetary accommodation, to improve, real economic variables, during recessionary times. And should also contract the money supply when the economy’s, you know, so-called overheating, and you get big spurts of inflation. I’m curious how… you’ve seen that play out, I guess, in your, … in your research of the monetarists, of how people think… how different monetarists have thought that money should be used in monetary policy.

George Tavlas: Well, I think Friedman wouldn’t always say that a monetary role should be used all the time. When we were in the Great Depression, he would… he would not have, … advocated a monetary rule. He thought that this was the time to employ activist monetary policy, expansionary monetary policy. What he does argue, however, is that by following a rule, we’re less likely to have episodes as we did during the Great Depression. The central banks sometimes do make mistakes. Sometimes they are under political pressures. We see that today, don’t we? That they follow… that they make policy mistakes because of the political pressures and for other reasons. And in order to keep the economy on a more even keel. you follow a policy rule. I think the same thing applies to a Taylor Rule. The Taylor Rule is an activist rule, because it involves the economy responding. To developments in the economy, whereas Friedman’s Rule does not. Friedman’s Rule is always 3-5% monetary growth. But, … The advantage of a monetary role is that it prevents policy mistakes from occurring. It prevents political interference with monetary policy. The debate continues. it’s hard to take a position on one side or the other, especially since I’m a central banker, and I don’t want to, … You know, I don’t want to prejudge this issue as a central banker.

Jon Hartley: I want to ask you about the current state of monetarism, and how… how it kind of fell out of favor. That is how monetarism, in part, has fallen out of favor at central banks and in monetary economics and in academia. So, you know, how I think of, I guess, the sort of rough history of these things is you had the sort of old Keynesians, and then around the same time in the 1970s, you sort of had both… in the 60s and 70s, you had both monetarists emerging, like Milton Friedman, and those that were highlighting MV equals PQ, which is, I think, very popular, in the public, in the public in general, and PQ is, I think, a pretty easy thing to communicate. And then, you know, for a brief period of time, the Federal Reserve, was targeting monetary policy aggregates in the 1980s. Then it sort of realized that money demand wasn’t quite predictable, and it kind of abandoned that, and then it moved toward targeting interest rates. Sort of in parallel, what was going on at the same time. In the 70s, you had the rise of the rational expectations revolution that influenced macroeconomists, you know, thinking, you know. Prescott, Sargent, and many others, who were very influential. And the challenge there, though, was that, you know, policy, monetary policy didn’t really matter, so you also had folks you know, the new Keynesians kind of emerged around that time as well. Folks like John Taylor, Guillermo Calvo, and later Mike Woodford, and, Rich Clarida, and many others, Jordi Gali, who argued that, well, if you have some sort of frictions, whether it’s, you know, sticky prices or sticky wages or or, seeking information, that, that you could… monetary policy could produce, real economic effects. You would get, monetary non-neutrality. And not only that, but you also have interest rates, as being sort of the key, monetary policy instrument in that type of modeling. And so, in the early 90s, there was, I think, this You know, pretty quick shift, along with when inflation targeting was introduced, to sort of put, interest rates as, as, sort of the key policy instrument of, of interest. no longer money, no longer, you know, thinking about the money supply. And then we, you know, then central bankers got very focused on, on targeting inflation, 2% in particular, largely, 2% inflation targets, and use interest rates to achieve that, and not necessarily target some sort of monetary aggregate growth. And I think we’ve kind of been in that regime for… the past, say, 35 years or so, where, you know, economists who are writing macroeconomic models write down these three equation DSGE models. You know, changing the DSGE models, and, yeah, essentially, you know, there’s, there’s a Taylor rule in there, a monetary policy rule, there’s a Phillips curve, there’s an IS equation, or, you know, think of as, like, an aggregate demand, kind of like an equation, investment savings curve. And… And that’s it. Money is nowhere to be found. So, I’m just curious, there’s some people who point to monetary aggregates as being sort of a useful indicator, maybe a predictor of inflation. And many people on Wall Street, I think, still use money and talk about monetarism all the time, but largely, when I hear about monetarism today, it’s not in academic seminars. or from central banks, it’s largely from Wall Street or, a few monetary, economists and a few monetarists, who are still out there. I’m curious, you know, what happened in your mind, and is money making in any way?

George Tavlas: I, think you got it pretty, pretty right when you, made the analysis about monetary aggregates were unstable in the 1980s and 1990s, and so central banks stop putting an emphasis on growth of monetary aggregates. When the ECB started in 1999, its main pillar for monetary policy was M3 growth. But that lasted for about 4 or 5 or 6 years, and it became evident that focusing on monetary growth for monetary policy was not the right way to go, that the aggregates were unstable and could not be relied on, and so, just like the other central banks, the ECB started focusing on interest rates, I think this is just taking into account reality. Now, in the year 2020, when, just before inflation started taking off, M3 in the U.S. jumped by, I think it was 35% in one year. We had a very… very large, perhaps not as large, rise in M2 in the Eurozone, and sure enough, a year or two later, we had big surges of inflation. Now, you can argue whether those surges were due to the to the monetary growth itself, to the financing of fiscal deficits, especially in the U.S, or to the supply-side shocks that came from COVID and the Russian invasion of the Ukraine. But in any case, it provided some… A bit of a rebound for the view that Money, as under monetarism matters, but it was just a… It was not a long-lasting… it didn’t make a long-lasting impression on monetary policy makers, but what is important is what I came… what I referred to earlier, is that, alright, we get inflation up, as we did in 2022-2023. How do we bring it down? We bring it down by wage price controls? Nobody ever talks about wage price controls anymore. We know they’re a failure. In the 1970s, we brought them down by high interest rates. Monetary policy. If you didn’t know the debates in the 1950s and 1960s, you would have never had suspected that monetary policy would become the chief instrument for dealing with shocks on the inflation front. So, again, a lasting contribution for Milton Friedman was the emphasis that he put, and other monetarists, that they put on… on, monetary policy, per se, whether pursued through by having the main instrument, the money supply, or the main instrument, the interest rate. And don’t forget, when we had quantitative easing. in the Eurozone in 2014-2015, that was essentially increasing the money supply to try and get the interest rate up, because We reached the lower bound of interest rates. We even had negative interest rates in the Eurozone, but they weren’t being effective in bringing inflation up, so we relied on quantitative easing, which meant buying… large purchases of bonds and increasing the money supply. So, I would not go… So far to say that monetarism as a emphasis on money is something that is no longer… being discussed. It has been used, it has shown to be valid in the year 20… years 2020 and 21, in terms of bringing inflation up, and monetary policy itself has been the main tool for bringing inflation under control.

Jon Hartley: Well, it’s, ….

George Tavlas: And one other thing, if I may, one of the, … tenets of monetarism, or one of… yeah, I would call it a tenet of freedom as monetarism, was the importance of flexible exchange rates. When Friedman first wrote his article on the desirability of flexible exchange rates in 1953. He predicted the demise of the Bretton Woods adjustable peg system. He said it couldn’t last. He said we would move to a system of flexible exchange rates. Sooner or later, we would get there. It was the only system that would… that would be viable and sustainable. He was right. In 1973, the world moved to a system of flexible exchange rates. That became part of monetarism. And so, … You know, when we say monetarism, it’s just not money, it’s other things as well. It’s rules versus discretion. It doesn’t have to be a 3-5% monetary rule. You know, we now think that a Taylor Rule works better, but it’s rules versus discretion. So there are a number of aspects to monetarism that have survived to this day, even though the emphasis on The quantity of money is not… The main element that has survived.

Jon Hartley: Absolutely. It’s, … It’s interesting, too, you know, you think about… and we’re talking about largely advanced economies, and times where I think inflation’s been fairly stable, I think, you know, even if setting aside the early 2020s, you know, inflation jumping to nearly 10%,

George Tavlas: Over 10% in Europe.

Jon Hartley: over 10% in Europe, but in the US, just under 10%. But, you know, I think about, you know, all these episodes of hyperinflation, and … thinking to, you know, Zimbabwe, thinking to Venezuela, and thinking to all these episodes where you know, there’s been massive amounts of inflation. You can see, you know, there’s, obviously in all these cases, there’s a massive surge in the money supply. And, you know, there’s… Tom Sargent’s very famous paper, “The Ends of Four Big Inflations”. And it is… that in particular looks at all the interwar, European countries. Germany, you know, Weimar, Germany, Austria, Hungary, that had these, massive inflations, you know, they were trying to essentially inflate away their, their, their war-related debts, in… it’s interesting how, just in all these cases, money is there, and it’s, it’s expanding enormously. And so, you know, all these regressions, that I like, to show of. you know, monetary policy growth versus inflation. When you plot all these… all this cross-country data, you see a pretty clear relationship that you know, when you have massive inflations, there’s always a money story there. Now, when we get into, you know, low inflation environments, like in advanced economies. you know, it’s less clear that there’s, you know, such a direct relationship between money and prices at lower levels of inflation, but at big, you know, with big hyperinflations, money is always growing enormously. So I think, you know, Friedman’s maxim that, you know, inflation is always and everywhere a monetary phenomenon. bears a lot of truth, I think, you know, especially with larger inflations, especially with looking at the cross-country and historical evidence. So I think, I think there’s a very good, I think monetarism, itself for this idea that money is behind inflation certainly, I think holds up, well, especially when we look at, larger inflations. George, I really….

George Tavlas: It also holds up at 5-10% inflation rates, too. There have been studies done that show that the money is a predominant cause of inflations in the levels between, as I mentioned, 5% and 10%. It’s only at low low frequencies of inflation, 1%, 2%, 3%, that money is not an important variable these days. But at the medium frequencies and the very high frequencies that you mentioned, it’s always a predominant cause of inflation.

Jon Hartley: Absolutely.

George Tavlas: So, one reason why, perhaps less emphasis has been placed on money over the past 25, 30 years. It’s because we’ve had low inflation rates, but as we know, we had a high inflation rate in 2022, 2023, and we also know that that was preceded by very high rates of money growth, both in the U.S. and the Eurozone.

Jon Hartley: Well, it’s been a fascinating conversation, George. I really want to thank you for coming on, and for all your excellent scholarly work on monetarism and monetary economics, as well as all your public service. It’s a real honor to have you on.

George Tavlas: It’s been a pleasure and an honor, and I thank you so much for having invited me.

Jon Hartley: This is the Capitalism and Freedom of the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m John Harley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Cliff, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Cliff Asness, who is the co-founder and managing partner of AQR Capital Management, a quantitative investment manager. Cliff also has a PhD in finance from the University of Chicago Booth School of Business, where he studied under the Nobel Prize winner Eugene Fama as well, and he’s here to talk all about asset pricing and financial economics. Welcome, Cliff.

Cliff Asness: Thank you, Jon. Thank you for having me.

Jon Hartley: Well, it’s a real honor to have you on, and, really, want to get into, start with getting into your earlier, early career. Where did you grow up, and how did you first get interested in economics and finance?

Cliff Asness: I was born in Queens, New York. At 4, we moved out to Suburbia on Long Island, and I grew up in, you know, post-World War II suburban… housing out there. I was not interested in finance for a while. I was kind of a only half-engaged high school student. Mediocre grades, good boards. Ended up… my father, found this program at the University of Pennsylvania, where you got a dual degree. You got a degree in… from the engineering school and from the business school. He said, you should do this, you have no clue what you want to do, so study two things. That was about the depth of it. I went there. It actually was not me, I was not a young, you know, read the Wall Street Journal, trade stocks at the age of 7. It wasn’t until I took one or two finance classes as part of the Wharton curriculum. that I was like, this stuff’s pretty cool. So I got interested in a very boring way. I took the classes And… and like them. Though my dad, again, influenced my career a lot, because I had always assumed that even though I was studying two fairly mathematical topics, that I would go to law school. Because my dad was a lawyer, I had several uncles who were lawyers. And at some point around junior year, I actually registered for the LSATs. And my dad said, what are you, crazy? None of us can add. You can… you do math. You should do something with math, and I switched it to the GMATs, and ended up at the University of Chicago’s PhD program.

Jon Hartley: That’s fantastic. And I know, so you went to Wharton, Penn Wharton studying engineering, and finance as well at Wharton, and I think, I don’t know if they call the M&T program,

Cliff Asness: They did, it was the early days of the program.

Jon Hartley: It still exists and is a very, a well-known, program that is a super selective program that students go through. My understanding is that you also met your great longtime friend, Jon Beinner there who would go to Goldman Sachs right after college, and you’d work again with later. He went to run the fixed income group at Goldman Sachs Asset Management for many years. You instead went on to UChicago for your PhD, and you study financial economics under Fama. What was studying with Fama like? And this is around, I guess, the 1980s; what was Chicago like at that time? What was in the air at that time? And, my guess is there were so many Nobel Prize winning economists at the time, and many of the, you know, the so-called Chicago School were around at that time. My sense is, in the financial economics side of things, too, a good number of folks that intersected there as well. I’m curious, what was in the air when you were there?

Cliff Asness: It was an amazing time to be there. I think, historically, there have been a lot of amazing times to be at the University of Chicago studying economics or finance, but for me, I always point out that my entire career was, in some sense, a lucky break. Because I got there in the late 1980s, I think I showed up in fall of 1988, And that was… basically just when Fama and French were doing… their first paper on the cross-section of expected stock returns. It was probably a working paper at that point, I don’t remember exactly. I could be off by a year or so on my stories, I’m getting very old. But I was essentially there when what we’ll today call factor investing, what we might call systematic value momentum, systematic momentum investing. I was there at the infancy. And that’s all… there’s always some luck, to… to these things. And even when you look back, it’s funny, terms like value investing, terms like factor investing. We didn’t use those terms back then. Factor investing came much later. I’m pretty sure the first couple of Fama-French papers didn’t call, like, their price-to-book factor “value”. I think that came later. But when you have some amazing teachers, Fama-French were co-chair of my… co-chairs of my dissertation, I think you’re currently sitting in John Cochrane’s office, he was on the outside committee of my… my dissertation. When you have these amazing teachers, and they happen to be breaking ground on what will be probably the major field of academic finance for the next 20, 30 years, you gotta consider yourself pretty, pretty lucky. So it was a pretty amazing place to be.

Jon Hartley: You know, to be there at that time, Fama-French factors are sort of new, those were eventually published in the Journal of Financial Economics (JFE) in 1993. I’m curious, who else was also crossing paths with you at that time? You know, you know, when we talk about momentum investing, you know, Mark Carhart, a fellow Fama student as well as Ray Iwanowski. These are all people that you hired later at Goldman Sachs. But I’m curious, who else was there, maybe, at the time? Obviously, Fama was working with Dimensional Point Advisors, David Booth and others. Dan Ivacsyn and Manny Roman (who now run PIMCO) went through Booth in around that same time as well. Did you know any of these other people that like yourself, would go on to, if they hadn’t already started them at the time, go on to run these massive, multi-billion dollar asset managers?

Cliff Asness: Sure. Mark and Ray. Again, my memory’s fuzzy. I’m pretty sure I knew Ray, and I think I knew Mark, and… in the program, or at least I knew him through mutual friends. You know, I mean, you’re a PhD student, you know, a few years into the program, you’re not quite in all the same classes together, and I was a few years ahead of them. Mark and I have an intimate connection, not just hiring him, but the momentum factor that I wrote my dissertation on he included in what became a four-factor model when he analyzed mutual funds. So we have that connection, and later on in my group at Goldman Sachs, I hired Mark and Ray. Ross Stevens. Was 2 years behind me in the program? I think it was 2 years, and I was his official mentor. Somehow, I agreed to do that. I didn’t even know Ross. I don’t think I mentored anyone else. But Ross has built an amazing business at Stone Ridge. So he was there. A lot of, you know, big-name academics were still there. Merton Miller was still there. I didn’t, I didn’t really know Merton until I went to defend my… or propose my dissertation. A scary time to meet Merton when you’re presenting your dissertation. And it was amazing. I’m sure a lot of people have the same memory, but the finance seminar was, like, Tuesday late afternoon at the University of Chicago, and people sat in the whole U, And you were at the front? And on the far, far right, Fama sat, and on the far, far left, Merton sat. Merton got into my dissertation, and it ended up being very good. It was nerve-wracking, but he liked it. But I’m going back and forth. It was like a tennis game where my neck was in trouble. At one point, Merton is asking a pretty hard question. And Fama is answering it for me, because he’s read my paper 20 times at that point. And I started to interrupt to answer it my way. And I had a moment of clarity, thank God, where I’m like. I’m not gonna interrupt Eugene Fama as he answers the question for me. So, it was a pretty heady time to be at Chicago. Antti Ilmanen, who’s one of my partners at AQR, was my year, in, in the program. My two co-founders of AQR, John Liew and Robert Krail. were one year behind me in the program, and I don’t think I met Bob physically there. I think I met him later on, through probably John or Ross. But, John, John and Ross ended up being my first two hires at Goldman Sachs, along with, Brian Hurst, who was our analyst. And then Bob and John ended up leaving Goldman with me to start AQR, so it’s fair to say Chicago was responsible for an incredible number of good things in my life.

Jon Hartley: That’s, fantastic. And I guess, just to close the thread on sort of the Chicago years, like. when you were presenting your dissertation on momentum, and I think this was maybe at the time when yourself and, you know, Sheridan Titman went to… you know, momentum was on the left-hand side, you know, the equation, and then Mark sort of brought it on to be one of the factors on the right-hand side.

Cliff Asness: That’s well done.

Jon Hartley: With the four-factor model (with momentum) was there an aversion to that? You know, I think of Chicago and Fama as sort of being very risk-based, into risk-based factors, and, you know, momentum never really squares neatly into. you know, this idea that, you know, stocks that have outperformed… when we say momentum, for the listeners out there that aren’t familiar, momentum means, you know, stocks that have outperformed in the past 12 months are going to continue to outperform. Those that have underperformed in the past 12 months are going to continue to underperform. I mean, that sort of doesn’t really fit into the standard sort of rational factors of, you know, value and, size, or the, you know, Fama-French factors. Was there aversion to this, or in a truly Chicago.

Cliff Asness: it’s a great question, because… as I’m… I’m finding these things, and I should say Jegadeesh and Titman deserve pride of place. I was probably only about 6 months behind them, which I will regret forever, but I… I think that, you know, we should say that I think they’re the discoverers I mean, people are trading momentum on actual Wall Street forever, but the academic, kind of, formal discoverers… I think my version of it was a better formation, I’ll give myself that, but they deserve that. I was actually nervous about telling Gene who I’d never… I still today have trouble calling him Gene. He tells me to all the time, and it’s Professor Fama, I’m much more comfortable with that. But I was nervous going to tell Professor Fama that I wanted to write a dissertation. Wasn’t only on Momentum, but that I was including this result in a fairly prominent way. And I… distinctly remember telling him, I want to study, price momentum for choosing individual stocks. Cowardly mumbling, the second part, that it works very well. Because you’re right. Instinctively, you know, for any so-called factor, a factor is if you sort stocks or other assets, but we always think about stocks first, if you sort stocks on this characteristic. ones at one end of the sword tend to outperform ones at the other end of the sword. For any factor that you believe works. There are always two possible explanations. An efficient market story. Where the ones that are attractive on that factor are, in some sense, as a portfolio, not individuals. Riskier than the other ones, and therefore you get a return premium for bearing risk.

The other is a market inefficiency explanation, where, you know, it’s not really a formal kind of measure of risk, it’s a bias, people have, an error they’re making. Taking the other side of errors can still be risky in the short term. But it’s not a so-called price risk, it’s not… Correlated and covarying with some… Stochastic discount factor that we care about.

You can come up with a risk or a behavioral explanation for any of these factors. The plausibility, I’ve always found, and I think the industry would agree with me, the plausibility of a risk-based explanation for momentum it’s pretty hard to swallow. It’s pretty hard to swallow. I think I… I think probably also trying to appease and curry favor with Fama. I think I called it the fool’s strategy when I started. Just buy what’s going up and sell what’s going down. People have tried, I’ve never seen a very satisfactory, oh, this as a portfolio represents risk. It has a bad left tail, but that left tail seems to be, if anything, a negative beta, not a positive beta. I’ve never seen… I’ve never seen a really good story for that. But I’m telling Fama, I mumble the second part. And he hears me. He probably… actually, I think he probably made me repeat it once, but… so I say, I want to study, price momentum, and I find it works, very well. And he pauses for a second, and this still had a profound impact on me. It was a very, cool moment. He just goes, if it’s in the data, write the paper. Which is about as close to a religious statement you can get at Fama.

That man’s respect for data, no matter what his prior might be. is, is extreme, and it’s actually, it’s actually very, a great role model. I think he’ll be the first to tell you he never has liked that momentum works. I think he’s called it the principal black mark on their, kind of, 3 and ultimately 5 factor. models, but he doesn’t deny the historical results. If it’s in the data, Fama wants you to write the paper. So that was a scary moment, as you intuited that it might be, but it ended up being quite a warm and nice moment for me.

Jon Hartley: That’s, that’s fantastic and amazing to hear, about, about Fama. I’m curious, so, you know, you’re a PhD student in, you know, your later years. Were you ever thinking about becoming a professor, or you just knew that you wanted to sort of apply all this research in practice.

Cliff Asness: No, no, when I entered the PhD program, I assumed I was going to be a professor. I got slowly seduced to what you might call the dark side. You mentioned my friend Jon Beinner. I should explain why you mentioned him, because you also worked at Goldman Sachs Asset Management, where John ran fixed income for many years. He was much more junior in 1991, when John and a few other people I knew working there offered me a summer job, I was still a PhD student. And it was, come for the summer, see what you think. I went there, I had a fun summer, and they said, come for a year, you can work on your dissertation part-time, see if you like it. And I did that. And at the end of the year, maybe it stretched to more like a year and a half. I still hadn’t really decided. when… again, dumb luck. Any story that you think ends well, and I hope it’s not the end of my story, but I hope it has gone well. Any story that has gone well has a lot of luck along the way, and I always try to be humble about that. PIMCO, the West Coast, you know, most known for fixed income, huge, respected money manager, read the first piece I wrote in the Journal of Portfolio Management. It had the exciting title, “Option Adjusted Spreads and a Steep Yield Curve”. The movie version has yet to be made. But they… they like the paper. Ended up calling me and said, would you be interested in coming out and starting a quant group for us? And… I did talk to them, they offered, they actually did offer me a job, and I was incredibly naively honest. I walked up to my superiors at Goldman, and I said, I think I lucked into this, but I think this is what I want to do. I can… I can pursue the academic stuff that I really have grown to love. And I can see if it works in the real world, which I found very attractive. And I will have to admit, I did notice that if it works in the real world. you probably make a little more money than a professor makes, and someone who says they chose Goldman Sachs over being an academic and doesn’t kind of admit that was at least part of the equation for them is probably not telling the full truth. And the partners I reported to said. Hey, we’re looking to start a group like this. And, to this day, I’m not 100% sure that was true. or if they were just really opportunistic and quick on their feet. I think it was probably true. I think there, I got lucky again. This’ll really date the story, because this did not end well, but I think Goldman wanted to start a group doing this, having really no idea what this group would do. Because of the then-success of the hedge fund Long Term Capital. About 6, 7, 8 years later, in 1998, that did not end so pleasantly. But they helped, they helped me out a lot in my life, because, Goldman, I think, was like, these guys are making a ton of money, they’re academics, applying their stuff to Wall Street. You know, Cliff, why don’t you try to do that here? And we didn’t do very similar things to long-term capital, but I told Fama and French. I think I’m gonna stay and do this. This is perfect. Fama was not happy with my choice. He wanted me to go on the academic job market, and it still saddens me, because I love Fama, and I didn’t want to make him, you know, I didn’t want to cause unhappiness. I do take it as a bit of a compliment that he was… that he was upset. If he thought I wouldn’t be a good academic, he wouldn’t have been upset. But I still remember his comment to me. I told him, I think I’m gonna stay at Goldman Sachs and build this group, and he just goes.

Jon Hartley: Why do you want to stay and be a salesman?

Cliff Asness: And it was a very Fama-esque comment. You know, and I was… I would never say this to Gene, if he hears this podcast, I’m saying it now. I was thinking, you guys work with DFA, right? You do this, and I’m just gonna do it from over there. So there are points on a spectrum, but… yeah, I saw the opportunity to pursue the academic stuff, trade it in the real world, and do really well if it worked.

Jon Hartley: Well, I’m just curious, I mean, like, how Goldman was set up at the time. I mean, my sort of sense of things, understanding a bit of the history, is that you know, Goldman was a big innovator at that time, in the sense that, you know, there were people there, like Fisher Black, like Bob Litterman, that were in the fixed income research group. This was sort of even before Goldman Sachs Asset Management came to be, I think, in the early 1990s. And I think that’s kind of where yourself and Jon Beiner and Sharmin Mossavar-Rahmani and all these other folks kind of come in. But, I mean, the fact that, one of the co-founders of the Black-Scholes-Merton model was at Goldman. Black-Litterman optimization was invented at Goldman and is still being used in portfolio management. I mean, Goldman Sachs, you know, at that time was, you know, a hugely innovative environment. It totally makes sense that, you know, young Cliff Asnesses would want to work there, and to this day, you’re still writing academic papers, so it never stopped you from doing research as well.

Cliff Asness: No, no, and that was a major attraction of it, the ability to fuse both worlds. Who was who and who was where is a bit complicated. Bob Litterman was on the sell side, not on the asset manager side at the time. He actually came over, when I left. to run my group, actually in a broader role than I had, to run my group, among other things, but he moved to asset management I think it’s a direct response to myself and a few other of our member… our group leaving. Fisher Black being there was some of the, again, dumb luck in my life. I got to spend a lot of time with Fisher. He was really a sounding board, he wasn’t building models, with us. I remember one time I was showing him one of our early models. he kept calling it a DM model. And I… I kept thinking he meant Deutschmark, because there used to be a Deutschmark. And… He actually meant, is it to data mind? And I didn’t… you know, he was using it as a shorthand, but Fisher was great. One of the Fisher stories I love… is he wrote a paper that was quite critical of some of Fama and French’s early work. And his first line of the paper was, Fama and French misinterpret their own data. I could be slightly off on that, but I’m getting very close. He only thanked a tiny group of people, including me. And from the bad luck of alphabetical order, I’m the first one thanked. I am not done with my dissertation yet for Fama and French. So, I should have given them more credit, but I call up Ken as soon as I saw it, and I say, you know, I gave Fisher some comments, but I don’t agree that you’re misinterpreting your own data, and Ken was like, we know Fisher. Don’t worry, don’t worry. Because Fisher was absolutely brilliant. suffered from less groupthink than anyone I’ve ever met. The Emperor always had no clothes for him, he’s always willing to say it. But I will say, 9 out of 10 things he said. we’re a little, this is very, disrespectful, but we’re a little wacky sometimes. The tenth one? Was brilliant, and nobody ever thought of it, and it was well worth the price of… admission. But that, that, that did scare me. But, Litterman was on the sell side, came over after I left, but we did use a version of Black Litterman in building our, our, our process. So yeah, there was a guy, Bob Jones, who doesn’t get enough credit in the quant world. Bob was running a Quant Equity product. Again, I don’t think we even called it factor investing, but doing a lot of the early stuff, and some innovative new stuff of his own. And he was a very early practitioner of quantitative investing, and he was there. So yeah, it certainly was not even close to just me. I was… I landed in a fertile environment.

Jon Hartley: That’s fascinating. So my understanding is, like, you came in into the summer, you’re working on fixed income stuff, for the most part, and then…

Cliff Asness: The summer was fixed income. When I came back for the year, it was fixed income, while writing my dissertation on what we would now call quant equity, including momentum, at night and on the weekends.

Jon Hartley: Fixed income by day. Quant equity by night.

Cliff Asness: Yeah, later, it was probably the hardest, craziest time of my life, except many years later, my wife and I had two sets of twins, 18 months apart. when I was building AQR, so that was a fairly similar crazy period, just with a different nocturnal activity. Instead of, instead of writing, you know, laboring away at a keyboard at night, I was feeding and changing children. If my wife watches this, she’s gonna go, you didn’t change too many children, so let’s… I might not send this one to her.

Jon Hartley: That’s too funny. So, I guess it’s fair to say, was Quant Equities always sort of your passion, and that was kind of what sort of led them to say, “hey you know, Cliff, we need you to start a quant equities group, or a quant group in general, also maybe do quant macro assets as well”. And then that was sort of the impetus for starting these two groups, you know, I think one was called QS (quant strategies/macro), one was called QE (quant macro). Now I think it’s still called Quantitative Investment Strategies (QIS) years later. But that was sort of the impetus for AQR.

Cliff Asness: You’re giving us, you’re giving us all way too much credit. It was not that well thought out. It was thought out at the level I said before, that other people seem to be making money with academic stuff. Let’s see if Cliff can build a group to do that. In fact, the way I remember it, for the first, I don’t know how many weeks. We were kind of walking around a little nervous that we had nothing to do. we started a quant group, and it was… and to some extent, nobody had a real plan for what we… I think they thought I had one, and I thought they had one. what happened, Bob Jones was doing the quant equity. We ended up doing a parallel effort, but we weren’t gonna touch that, early, early on. He was doing a good job at it. there was a group run out of London, non-quants, active, you know, concentrated stock pickers, running a portfolio that had done well, but had hit a very rough patch. I think we did the performance attribution on them, and it turned out that they were actually pretty good, at least ex post. I… the statistical validity of this, I have no idea if we were… if we had a t-statistic above .5. But in the performance attribution, they had been good stock pickers country by country. And always in the wrong countries. So, the first thing Goldman asked us to do was this macro question. Can you decide where in the world to invest using these quantitative methods? I think I said, of course we can do that! Give us, give us some time, and then our four-person group got in a tiny room. And we said, how are we gonna do that? I said, of course, before I had a clue. Embarrassingly, because I think it’s kind of obvious what we did, it took a little bit, but within a day or two, we just said, countries are just portfolios of individual stocks. This is childishly simple. If we aggregate up the numbers that people like Fama, French, my dissertation, had been building factors on If we aggregate them up for countries, if Germany is double the price to earnings, price to sales, price to book of France. And has worse one-year price momentum. You normally don’t get that because they’re negatively correlated factors, but if that… Will… do you expect Germany to do worse? And the answer, of course, was yes. This is a bit of a cooking show. I got the cake already baked in the back. I’m taking you through the steps, but I know how it turns out. And we built a tool that… that… that the active group did use. We ended up building it for stocks, bonds, and currencies, using different factors, but they all were some version of value, momentum, or what we might today call a carry factor. What does it pay you if nothing happens? But we also realized pretty quickly that we can give advice to the, to the active groups at Goldman, but we could also directly run money using these. So by near the end of 1994, Goldman Sachs ceded something called the Global Alpha Fund, that… Use both macro and… our version of what Bob Jones was doing, though we ran it separately, of a quantitative equity model to run a series of long-short strategies. Long-short country futures, long-short bond futures, long-short currencies, and then long-short individual stocks within many of these countries. All with a goal to be market neutral, very aggressively, targeting very high vol… And that grew into a lot of the things that we did.

Jon Hartley: That’s… it’s an amazing, history, and also just all the… I think all the people that I… my sense that you helped hire and bring in, you know, people who are PhDs, you know, many of whom, you know, I think, you know, folks, and many of whom at the University of Chicago, you know, at business school. I think Mark Carhart, Ray Iwanowski, I think, you know, maybe Giorgio DeSantis, you know, there’s, also.

Cliff Asness: Giorgio was after me. Mark and Ray hired Giorgio when they took over when I left.

Jon Hartley: Okay. Well, then there’s also, you know, Don Mulvihill, he was early, he was a University of Chicago guy, as well, you know, built their big, tax, tax loss harvesting strategy, which is one of their largest strategies, to this day, and many others, you know, who came to… to lead the group, Katinka Domotorffy, Gary Chropuvka, and others. I’m just… so, you know, fast forward, I guess, 5 years later. you know, the infancy of AQR. You started it in 1998, with John Liew, Robert Krail, and Dave Kabiller. Some of these were classmates of yours, and were working at Goldman Sachs as well. What was the impetus for starting AQR and going out on your own, and starting something totally de novo?

Cliff Asness: 80% naked greed. I think we did the math and said, as well as you can do at Goldman Sachs, if you build your own asset manager, you do somewhat better. Again, it’s very similar to me telling you, earlier, that, that, that going to the Goldman, as opposed to academia, had something to do with how well you do. It’s just being honest. I think 20% was an early recognition on my part, that I don’t always work and play well with others. That, you can’t say whatever you want at Goldman Sachs. You can’t say whatever you want at AQR. Only I can.

Jon Hartley: A company has to have some, you know…

Cliff Asness: if someone at AQR suddenly has an opinion that a product of ours isn’t great, there absolutely should tell us that we should debate it. But if they went out and submitted a paper on it without telling us, that would be upsetting. And I knew I wanted to be the guy who could say and write what what he wanted. Again, I’m not claiming some altruistic, this is, I’m giving it 20%. The 80% greed was still, was still there, but I think I pretty, early on, even though I loved Goldman, Goldman was very kind to me, I did well at Goldman. realized that I, that I, that I was a guy who ultimately had to be on his own. And then, David Kabiller, still, co-founding partner, still my co-founder, still active today. He deserves a lot of credit. At some points when we’ve had tough times, I wanted to blame him. But… On that credit, because he spent the better part of a year convincing me that if we left, and it became a we. it could work. People would actually invest with us, because I… I was not the… as secure about this stuff as I am now. This notion that a bunch of people turning 30 could leave and attract capital, I had to be convinced of, and David did convince me.

Jon Hartley: That’s, that’s fantastic and so great to hear. It’s amazing, in how, transparent AQR is in terms of its investment process, in terms of the factors that you’re using, and it’s… it’s amazing how many, sort of public goods that you’re sort of generating, and doing research, and I think, in many ways, succeeding you know, Goldman Sachs Asset Management, just in terms of the amount of research and output that you’re doing, on factors and various things, and AQR has been a real leader in this respect, in factor investing.

Some of the biggest factors, I think, that you’re… you’ve been focused on, and as other investors have, value, momentum, quality. In the factor-based investing world, you know, there’s been a lot of discussion about, what factors have, you know, the greatest, sort of relevance and sort of staying power. You know, AQR is also taking the lead on some new factors, like low volatility, betting against beta as a factor. I’m curious, where do you stand on your favorite factors?

Cliff Asness: You know, it’s funny. This does not affect the weights we put on things. We’ve actually moved to a more systematic approach. To weights, it looks at in-sample, out-of-sample data. So, favorites, I would be terrified that someone would think I’m sitting around, you know, and just overriding all the data and saying, I kind of like this one. But I’ve always thought, two of the originals, which still matter, they don’t matter as much as they used to, because the models have grown, but the value and momentum stuff. I’ve often joked, that… it’s almost a raw shock test, almost a personality test. Someone that’s either wired to be a contrarian, or to be a jump-on-the-bandwagon person. And I can’t test this, but I’ve always thought one of the harder parts of active stock picking Is that these two things do really work. And it’s hard to keep both in your head at once, because you’re wired for one or the other. You know, all else equal, I’m wired to be a contrarian in almost every part of my life, sometimes excessively so. So… Favorite in maybe an emotional sense? I’m, at core, a value guy. I… don’t think, certainly not today. I think in the past, I probably let that, let me overweight it, maybe even a little too much. We’ve certainly moved away from that over time. But if I had to have a favorite… I also love the fact that value You know, can work for a host of different reasons. I think it was, Ray Ball, I hope I have his first name right, who wrote a paper in the early days of Factor Investing, who pointed out that value’s kind of a catch-all for expected returns. It can be behavioral, it can be risk, premium, but for the same cash flows, if expected returns are higher. The multiples all else equal lower. So it, it, you know, the theoretical justification, no matter what the empirics. Now value, of all the factors we trade, value is probably the most episodic. Meaning it’s not IID. It goes through some long periods of being in favor and long periods of being out of favor. I think that’s probably part of why it doesn’t get arbitraged away. You know, after a lot of years marketing these things, I’m pretty good at turning a negative into a positive. But, you know, the harder something is to do. the more plausible it is that not enough people do it to make it go away. So there’s always good and bad news when you say something is hard to stick with. The bad news is it’s hard to stick with.

Jon Hartley: The good news is that may be why it doesn’t…

Cliff Asness: Go to zero. But… You know, I love… but I love momentum. I’ve never been as much a momentum guy, even though it’s somewhat one of the things I’m known for in academia, is being, you know, after Jegadeesh and Titman, very early in creating that. That is, again, more emotional. That’s a matter of personal preference. I used to do… I finally stopped about a decade ago, but for the first, like, 20 years of doing this, I’d make the same annoying joke when people would bring me a trade that we were doing, and I’d look and I’d go. Are you telling me we’re buying more of the Japanese yen because it is more expensive than it was last month? Because that’s what momentum does. And often that would be more important than evaluation in the short run. And someone would look at me, they got the joke at some point, very deadpan, and go, yes, that is what I’m telling you. And I’d be like, okay, I was just checking. Because, you know, in the… in some fiber of my being, it just… that would always just bug me. But… Being a value momentum… being a value investor without momentum would scare me, because value does have its long, dark periods, as they said about Winston Churchill in the 30s, in the wilderness. Betting against beta is one of my favorite factors, because the empirics are so strong. And because the story is so beautiful, it’s simply… it’s a basic CAPM story with restricted leverage. Where leverage is… people are either unwilling, or it’s too expensive to do, and it leads directly to low beta stocks, which really help you in a world where you lever the tangency portfolio. But if you’re unwilling to do that, they’re kind of orphans. And it’s a very, very sweet story that shows up in the data very nicely. Profitability, one of the quality factors. I love, because it’s empirically so strong, I think it’s one of the weaker theoretical stories. I don’t have a great… frankly, we’ll do things for different combinations. We like to have both. But a super strong empirical story. and a less strong theoretical or common sense, even, story, or vice versa, can still get you in the process. You’ll get more of a weight if you got both. I’m actually dating myself. We’ve changed to a more systematic approach, so that’s… that’s a little less true than it used to be, but I’m just gonna… I’m just gonna go with it. But you’re asking one of my favorites. I love the empirical results in and out of sample of profitability. I’ve never liked the stories. Why you should get paid? For buying more profitable companies? I’ve never seen anyone, and I don’t keep up with the academic literature quite as much as I used to, but I’ve still not seen anyone come up with a great theoretical story for why you should get paid for that. Though, it’s so strong empirically in so many different places. It’s past the out-of-sample test. So, yeah, I have different loves, and ones I’m a little more queasy about. But, again, we don’t… let my loves and queasiness matter. I don’t think we ever let them dominate, and we don’t let them matter as much as they used to.

Jon Hartley: I’m just curious a little bit about, market time… or, sorry, factor timing, let’s just say.

Cliff Asness: Okay.

Jon Hartley: And you’ve, I think, always, and correct me if I’m wrong, I’ve always sort of seen you as a critic of factor timing a bit. And I’m just curious how investors should maybe think about periods where, like, traditional factors like value underperform for over a decade or longer. Like, obviously, value in the U.S, you know, has become a, you know, betting against tech-specific story, which, if you’ve been doing that for the past 15 years, it’s been a very difficult thing. Obviously, you know, you can… Do, sector, neutral sorts, where you’re doing, you know. You still have the same weight That, you know, the tech… sector will have in the, in, say, the S&P 500, but then you’ll, you know, within each sector, you know, you will pick stocks that have the most value, so you’d still have the same overall tech exposure, for example, but you just would pick the tech stocks that have the most value. What do you think about that? I mean, there’s lots of investing people out there that are trying to time the market, sort of, and have various sort of market timing strategies. You know, when you have a big, crash in the S&P, you know, your expected returns go up. I’m just curious what you think about factor timing, market timing in general.

Cliff Asness: You asked a ton of stuff in that question, and I’m not gonna remember all of it. But… First, on the industry adjustment thing, the sector adjustment thing, I think we were the first to do that. Myself and Ross Stevens wrote a paper in 1995, never published, but you can still find on the SSRN. And I think we get pride of place on showing that most factors, and I think value is particularly strong. do better if you do it within industries and don’t take an industry bet. That the apples to oranges, you know, to go to the extreme, comparing tech to a textile. on price to earnings. Are you ever gonna not be short tech? And can that be right? To have a permanent… bet. Momentum, was the only one that, had very similar power for, for both. And I think that’s very intuitive, because there’s no measurement problem. Momentum is momentum. It’s return. Value has a big measurement problem. Does this… does this ratio mean the same thing for this industry as this other industry? So, I do, I do have to brag for a second. Value, the simple Fama-French definition, price to book in the U.S, I don’t remember, It’s on a… certainly more than a decade, probably like a 15-year drawdown. Versions of value that are global, which Fama and French do also, it’s not a knock on them. and that use more measures than just price to book, and don’t take that industry bet. The longest we’ve seen, which have been quite painful, have been kind of two and a half year drawdowns. Actually, you’re in drawdown for longer than that, so you have to make it back. But two and a half year negative periods made back in about that same amount of time. Where multi-factor processes are often not nearly as bad. Remember, except if a client specifically wants one factor for some purpose they have. we’re always trading a whole bunch of factors at once. So, you know, the value drawdown. The simple version has been out of favor for a while, though I wrote a piece defending it, just a couple years ago, called “The Long Run is Lying to You”. I mean, to most people, 10 to 15 years is an eternity. If you ran a practical investment product doing only this. 15 years later, only you and your mom are still invested, and your mom has asked for the redemption papers. She wants to know, kind of, what the rules are for when she can get out. But, in real life, at modest sharp ratios, remember, you know, if we’re trying to achieve a Sharpe Ratio, call it 1. And we have many, many factors in many, many countries. Each individual one can’t be close to 1, or otherwise we’d be a Sharpe ratio of 5. So they’re not giant… in any single country, one factor’s not a giant edge. So when you do the math, the standard deviation event You know, if you’re a .5, which is gigantic for a single factor, right? If you’re a .5 across tons of things, if you’re a .5, it takes less than a two standard deviation event to be down for a decade. So, these things, to a statistician, are often much less shocking than they are to a real-world person who has to go in in year nine and a half and say, still down. The other thing is, one thing I do think we pioneered, I’m bragging a lot on this call, you’re bringing it out on me, but during the tech bubble in 99, We were at least the first to publicly do this. You never want to claim you’re really the first, because we do things privately, we don’t write about, we don’t publish everything. Jon, we only publish the things we think are mostly out there. So I gotta give other people the benefit of the doubt, also. But we wrote a piece trying to measure the long-term, not short-term, attractiveness of the value strategy, and introduced this idea called the value spread that many others use now. And if you go back and look at the academic papers, all the early work were sorts, ordinal sorts. That built a portfolio of the better, and went short, or underweight portfolio of the worse. We asked the question, particularly because value was getting creamed for a year and a half. Okay, how extreme is it? And to our knowledge, at least publicly, again, we were the first to say, alright, pick your favorite valuation ratio. We looked at multiple ones. If you like price to sales, what’s the price to sales of the cheap portfolio compared to the expensive one? Is it more different than it normally is, or tighter than it normally is? And the idea is, when there’s bigger differences, when the expensive ones are at a much higher multiple than the cheap ones, then normal, they always look more expensive. Right? You created the measure, you sorted the stocks. If you sort on something, the ones that are higher will be higher. But how much higher varies through time, and we did find that if you have a long horizon, you know, 3 years is good, 5 years is even better. That there is some power to it. When that spread is larger, things go on. The value strategy will do better. When spreads are tight, the Sharpe ratio is lower. We also found, and here’s an example of publishing. I’m still a little bitter about this one. An official AQR publication strategy is the perfect AQR publication strategy is you discover something you think no one else knows that has some alpha. You trade it for a decade, and you write a paper on it a minute and a half before someone else is gonna write a paper on it. Cause it’s gonna be out there anyway, might as well get the credit. Obviously, that’s art, not science. And we’ve been trading the fact that factors themselves have momentum. They tend to trend for many years, and someone else wrote the paper, and we were very… I was very angry that we missed that one. We let someone sneak in before us. But that matters, too. In the short run, fighting momentum is always a problem, that this result repeats again, and again, and again. So… Never bet your life on factor timing. It’s still, particularly on an individual factor, pretty low risk-adjusted return. But the perfect time to like any factor is when it looks quite cheap versus history, but when the last 6 to 12 months are starting to look pretty reasonable. You never… like any value plus momentum strategy, you never nail the peak or the trough. Because you need to see it start to work? But because trend following is real. that’s a higher sharpe strategy, and when I’ve messed up in this field. It’s when I found the valuation so attractive that I’ve said, we gotta do a little even before the trend turns. Turns out the trend has tended to still, have efficacy. So I do think you shouldn’t do much factor timing. I think most of your factor timing should actually be trend-based, not valuation-based. And valuation only gets interesting when you’re at something I jokingly call the 120th percentile. You’re a guy who will understand. Sometimes I make that joke, and people don’t understand there is no such thing as the 120th. percentile, I mean, like, wider than you’ve ever seen before. But mostly, don’t do it, and to be totally fair. the times I’ve been most cynical about factor timing is when, one of my frenemies, Rob Arnott, is very, very into it.

Jon Hartley: Somehow, when he writes something, I instinctively take the other side too much, because Rob’s a brilliant guy.

Cliff Asness: So, I have been a little schizophrenic on factor timing. Historically, we’ve… we’ve not been… flighty in the portfolios. We’ve always done a little. with some valuation, and particularly trend following. Factor trends are just… we think they’re real.

Jon Hartley: Yeah. Well, I’m curious just, maybe a lightning round through a few of these topics that you’ve spoken about.

Cliff Asness: Fire away.

Jon Hartley: You know, one is… you know, in academia, at least, there’s a bit of a replication crisis. In fact, research has, I think, suffered a bit in academic science, and it’s not being published as much anymore. I think a big question is, you know, what are the real factors? And, you know, to what’s really p-hacking, what’s sustainable, and maybe when a factor is discovered, it’s arbitraged away and people pile into it. I’m just curious, you know, what you think about factor research, and how do we, sort of. This, over time, build an understanding of what are the essential factors in the structure of asset prices.

Cliff Asness: Sure. Again, you asked questions that I… I could not do a lightning round, I can go on for a long time. You know the literature well. It’s actually how big the replication crisis is in factor investing is a contentious topic. La St. Peterson, Brian Kelly, and I… they work with me, so I think they had co-authors, so I don’t want to imply it was just them. They take… the… the view in their paper that the replication crisis is not that bad. For one thing, I think some people hold it, hold replication to too high of a standard. Literally for close to 30 years. As a rough rule of thumb. We’ve said if we get half a backtest going forward. We’ll be thrilled. Because we know there’s some p-hacking and everything. I mean, obviously, there’s some things you might want to discount more, some you might want to discount less. Not saying it’s a be-all, end-all. Half is a pretty cheap and easy, kind of wimpy guess. You know, how many times in life do you just split the difference? But for… at least we’ve been consistent in our wimpy guess. That changes what you think of as success or failure by a lot. Against that standard. we find the results are fairly reasonable. I think value plus momentum has been about half of a backtest since we’ve started looking at it. So we don’t think it’s quite that bad, but obviously data mining, p-hacking, overfitting. is a perennial issue. When it comes to which factors are easier to arbitrage away? I think the hardest ones… R1’s, again, like the value factor. That’s based, I think, on… basic risk or behavioral reasons, and I’ve drifted more to the behavioral side over my career. I think it’s just proximity to Fama. Being away from Fama, I drift, and if I walked into his office, I’d probably snap back into the risk side, being a total coward who loves the man. But… Factors… say value is based on behavioral errors people make. That means they’re pretty deep behavioral errors. Overextrapolating good and bad times. Overpaying for them. Also, value, as it’s seen, as it’s shown us, goes through long periods of pain, even if it pays off long-term. Like we discussed earlier, that can make something very hard to arbitrage away. That could be bad news to someone living through it, but good news to whether it’s gonna be around for as close to forever as you can say in this business. Factors most susceptible to being arbitraged away are illegal information advantages. When I say information advantages, I’m quite careful to please AQR compliance and throw in the word legal. But if you’ve built a data set, and, you know, nowadays people call this alternative data, and we are actually fairly into it, we certainly do this, if someone builds a new data set and is only going to sell it to one or two managers. And that itself is a very interesting negotiation, because you have to decide if you think it’s real. They charge a lot more than traditional data, because they’re only giving it to one or two managers, but you don’t expect to trade this for 20 years. It’s an informational advantage. It’s, you know, you’re looking down through a satellite, you’re doing a credit card summary of what’s going on in the real world, and you have an edge for a while. But those con… any factor that’s about speed of info… getting information and acting faster than other people. You know, and unless you’re the fastest in the world, which some people do try to be. That is probably not even close to a permanent edge, and everything is on a spectrum.

Jon Hartley: Absolutely. Okay, next, question. How has machine learning changed, if at all, if at all, how, your systematic approach to investing at AQR works?

Cliff Asness: Well, it’s… it’s… creeping in is understating it, but it is… it is starting to show up everywhere. And I… I’m nervous saying this, because I’ve said this publicly, and the financial press has picked it up and overdone it. I’ve said that I probably slowed us down by a couple years in machine learning. Because… I was a little cynical. We’ve always told this story, like I was telling you, that we care about both data and story. And when you move into machine learning, you gotta lean more heavily on data, it’s kind of the point. Right? You’re not telling a story. You’re surrendering yourself, if anything, a little more to the data. So I’ve had a couple of headlines, like, Asness does flip-flop on machine learning. That kind of stuff drives me crazy, of course. Like, anyone in business is driven crazy, sometimes by the press. We invested a lot in machine learning. When it was all on the arm, when we didn’t know if it would work, we hired Brian Kelly out of Yale, one of the major machine learning, and I’m biased, but I think the top machine learning guy in finance. We, we explored and built machine learning, in, in our existing funds, people like Andrea Frazzini, Laura Serban here. So we were not… so cynical that we didn’t pursue it. I just had smaller hopes than maybe some others did, because I was so used to this world of being more worried about overfitting than anything else. And one thing machine learning does is it deals with very complex problems with more parameters. This is quite controversial right now in academia, and I will not try to do Brian Kelly’s job, because I’ll do it horrendously badly, but his paper,
The Virtue of Complexity”, arguing that ML changes the equation on how many parameters you can have and the dangers of overfitting versus underfitting. I think Brian’s right, but if I try to… I’ll lose the debate if I try to do it. But it is changing how we do things. There are factors where we usually can still get some intuition out of what’s going on. I think there are pure ML players that just throw away all intuition, and I don’t think we’ve quite gone there. But… Has ML moved us more towards the data? I got a question once, I never thought of it this way, from a client, about an ML factor, and saying, can you give me a precise, intuitive explanation of what it’s doing? I can go… I can give you a very imprecise one. But if I could be very precise about it, what is it doing? where’s the machine learning? What is it doing if I can just give you a off-the-cuff. easy one-line answer to it. You know, one of the primary areas where ML has helped so far is processing natural language. Being able to tell if something is good or bad news. And quants have done this for a million years. The old-fashioned way to do it is to build up keywords and phrases and assign numerical scores. Way oversimplifying. Do you see the word increasing? Plus one? Count up all, you know, similar words, and of course, you immediately see the problem. If the actual sentence was, massive embezzlement is increasing. Plus one was probably… Not your best guess. Now, quads can survive looking silly 47% of the time if we get it right 53% of the time. So I’m not knocking this old approach. I’m just saying it was very noisy. It turns out that applying natural language processing to language data, language is a very nonlinear thing, whether a certain word is good or bad. Might depend on this sentence, like the simple one I just gave, but it might depend on 3 sentences ago. Nothing is perfect, language is very complicated. But it turns out, NLP, applied to textural data to forecast returns, we found to be very powerful, and we’ve had some great success with it. I can tell you in general what it’s doing. It’s doing a fundamental form of momentum, or good things happening. But can I tell you precisely why it likes this stock? I cannot. And when you do ML, you often have to give that up, or again, what the heck is the ML doing?

Jon Hartley: So, next question’s, private markets versus public markets.

Cliff Asness: Alright, we’re shift… we’re shifting gears.

Jon Hartley: I know. You’re a big public markets guy, and also a bit outspoken on making comparisons between public markets and private markets. Obviously, private markets, just in terms of assets of totally exploded in, in recent years. You know, do I understand this right, that, you know, when you talk about so-called volatility laundering and making the, how you can’t really compare public market returns to private market returns, is that the issue is that with marks. how private markets do marks is that, you know, how they value themselves. It’s not just a… frequency issue, in that, you know, public markets, you have every tick that… the stream public markets, but it’s… it’s a… quality of marks that, you know, these firms, say private equity firms, are valuing themselves, and there’s a bit of a bias in terms of how they value themselves, and that kind of distorts, sure. …volatility and return metrics a bit for private funds, say private equity funds, comparing them to, say, public funds, publicly traded funds.

Cliff Asness: I’ll give you a short version of my complete private equity story. First, the term volatility laundering, which was mine. I… I feel kind of bad about, because it’s pretty snotty, and, you know, I’m not really implying anything illegal is going on here, I want to be clear about that. But laundering is when… Something doesn’t show up that’s there. the way… My sense of how most privates are marked. is… let’s go to two extremes. You can mark any asset at one of two extremes, or anywhere in between. You can mark it at where you can sell it at today. And even that has some issues. What if I tried to sell a ton of it today? Maybe you get a lower price. But you know what you’re trying to do. And for public markets, that’s quite easy to do. You look up the price, and you mark it there. The other end of the spectrum is you can market at what you think it’s worth. That’s not illegitimate. You know, that’s an interesting thing. My sense of the way where privates do is much closer to where they think it’s worth. I think if markets move, they factor that in a little. I don’t think they run to a zero beta, but they’re mostly marking to their model, to what they think the thing is worth. I don’t object to that if I get to do it too. What I object to, Is different standards, and then the worst thing is when these are mixed. And people will show an efficient frontier using… market prices for public assets And what the private people think it’s worth, prices, for the private. assets. And you’ll see this, you’ll see, some… some investors put out, their… their assumptions, and they’ll draw them on the efficient frontier, and they’ll have, like, public equities at 16% vol, or an expected 10% return. Private assets at a 5% vol with an expected 14%. return. You could debate the 14 versus the 10, But the, the, the 16 against 5? I think that’s what I said. You cannot debate that, that’s just not apples to orange… that is apples to oranges. And it’s… it pisses me off! Because I gotta live in the standard of what the market will pay me. I am just as capable of telling you what I think our portfolio is worth. when we started AQR, we started, I mentioned before, right before the dot-com bubble of the late 90s really took off. And we were down a lot before we did very well. Well, if I marked to what I think my portfolio is worth, I would have said, all these tech stocks that were short. I don’t think they’re worth this, so I’m gonna market to whatever I think I’m worth. And if I tried to tell my clients, actually, we’re up a little bit. I think they would sue me. Because they would say, no, you’re not, look at the prices. And what I don’t get is the private people can do exactly the same thing. They are the world’s best people at valuing a company. They could tell you where I could sell it today, just as easily as they could tell you where their model is, and for some reason, they get to do it one way, and I get to do it another. And that part of the story I am certain of. That their risk is much higher than you think. If we go through a 10-year bear market, that risk will show up, and that’s pretty much all you really worry about, is the giant bear market. So I do think they’re understating their risks. It can even matter for prospective returns going forward. Because imagine, and I find this very easy to imagine, because I think this is actually what’s going on, but imagine a lot of investors have grown to value this… Volatility laundering. It’s easier to stick with if you don’t have to deal with the real current mark-to-market prices, right? The public markets are way down in 2022, privates are only down a little. Easier to stick with. Well, in the early days, when David Swenson at Yale was pioneering using privates for institutions. It was pretty easy, and his book, “Pioneering Portfolio Management”, talks about this all over the place. It was particularly easy to say, you get paid a premium for owning the illiquid private asset, because who wants something not marked to market that’s hard to sell? Well, imagine today. And again, I think this is actually, at least to some degree, what’s going on. Imagine today that that is a desired feature, not a bug. That not having to mark to market and not having to report the full volatility is a good thing. Well, you pay up for a good thing. You accept a… you demand a higher expected return if you have to take on a bad characteristic. You accept a lower expected return if you have to take on… if you’re forced to take on… or if you take on a characteristic you want. So I think it can actually affect the expected returns going forward. I would not expect… I won’t tell you what I think it’s gonna be, it’s all over the place, but I… whatever premium… and this is fought over, because private data is private data, we don’t have the best, apples to apples comparisons, but whatever the past has been. My strong guess is privates will not enjoy the same advantage over public going forward, because what used to be a bug is now a feature.

Jon Hartley: That’s.

Cliff Asness: And I live in Greenwich, Connecticut, and I gotta be careful if I go near a golf course that people won’t aim at me. Yeah, there’s a lot of private equity folks out there now, increasing number of them. The old cliche applies to me. Some of my best friends are private equity managers.

Jon Hartley: That’s, that’s too funny. I hope they’re, kind to you. I want to sort of… my last Question or two here for you is really about your investment philosophy. And, I remember when Fama and Shiller both won the Nobel Prize in 2013, along with Lars Hansen. It was, I think, a pretty seminal moment. And… I mean, in part because, you know, they were giving a prize, to both, Fama, who is sort of the standard-bearer, the risk-based efficient markets view. As well as, Robert Shiller, who is, really the standard bearer of the, I would say, very behavioral finance view. And I’ve always felt that you are, you’re somewhere sort of in between. You recently wrote a paper, titled, “The Less Efficient Market Hypothesis”. I’m curious what you meant by that, and… Sure. …what your kind of broader view is.

Cliff Asness: Let me start out by saying Fama should have won a solo Nobel Prize 10, 15 years earlier than that. I’m still a little bitter.

Jon Hartley: You could still give him a second prize.…

Cliff Asness: I don’t know how often, I don’t know if that’s ever been done, but I know in the sciences, people have won in other categories. But it’s gonna be hard for… to get a second one in economics, I think. So I think Fama revolutionized the field. The efficient market hypothesis, no matter whether you believe it’s close to holding or not. is… is kind of the firmament we start with to test everything. So, you know, I think he’s the MVP of modern finance. With that said. making up numbers. I was never a pure behavioralist. Remember, I wrote my dissertation, a big part on momentum, which is very hard to reconcile with risk-based explanations. But I was probably 75-25 Fama-French risk-based. And I’m probably 75-25 behavioralist. At this point. You know, the real world smacking you in the head, living through multiple things where, I would use the word bubble. I’d use the word bubble about early 2000. I’d use the word bubble about late COVID, late 2020. I don’t use that word very much. I still use it a lot less than a fair amount of active managers. Twice in a career is not, I think, too abusive. But, Gene… doesn’t like that word. So, the less efficient market hypothesis was really a 20-page op-ed.

The Journal of Portfolio Management had its 50th, I think 50th anniversary, and they invited some of us who’ve been publishing there a long time to write. papers, and invited papers are awesome, because they’re not refereed. So you have all… you give a lot more latitude. Frank Fabozzi, the wonderful publisher there, I think he would do some quality control if I submitted something insane, but it’s not quite the same. He encouraged us to muse a little bit more. It was supposed to be like an old man reflecting on what they’ve learned. And I do think over my career, I have moved on this, and I think markets have actually changed somewhat. That value spread thing we described earlier, the spread between cheap and expensive. By March of 2000, the dot-com bubble hit levels that were not close to anything in 50 years of history. When the next 2-3 years happened, and we made way more than all that money back, and life was good, if you’d said to me, are you gonna see something as crazy in your career again? I don’t think… I hope I never would have promised anything, not just for legal reasons, but for intellectual reasons. Never say never. But I think I would have said very, very unlikely. For one. It was the biggest in 50 years. I, you know, as much as I’d like to live forever, I don’t think I necessarily have a 50-year career. Two, your question presupposes I and others like me will still be around. In your career. And we saw this. And then, by the end of COVID, it was getting close before COVID, so I can’t blame COVID for the whole thing. By the end of COVID, by late 2020, it was substantially wider a value spread, as we measure it. than we saw in the dot-com bubble. So if that doesn’t make you go, has something changed versus history over the last 20, 30 years? And I have a few hypotheses. I know you’re very, the inelastic market hypothesis, how that affects indexing and whatnot. The growth of indexing could matter. I am not… someone… who thinks the growth of indexing is the worst thing that’s ever happened in the world. There are a fair amount of people who are, I think, a little hysterical about it. But we all know that the classic kind of finance, you know, brain teaser, what if everybody tried to cap weight index? is gibberish, right? There’s literally nobody thinking about prices. Hard to believe we jumped to gibberish going from 99.999% indexing to 100. So the fact that we have a lot more people cap-weight indexing and a lot fewer people looking at companies, could that matter for this? Could that let prices drift further? I don’t have a formal model, but yeah, I accept that. My favorite hypothesis, and I stress the word hypothesis, because nobody knows, is I’m gonna really sound like an old man yelling at clouds now. But the social media environment, 24-7 gamified trading. I think most people of any political persuasion, won’t say everyone, because we have a lot of people with some odd views these days, but I think most people would probably agree that this environment has made our politics worse. It’s pushed us into bubbles. It’s… confirmation bias has gone… way up. It has made herd mob behavior Easier to get going. Markets are voting mechanisms. They’re not arbitrage mechanisms, they’re voting. mechanisms. The old Shleifer-Vishny limits of arbitrage. said, no, it could be an arbitrage, but if you can’t hold it, it doesn’t last. If somebody is making an error. Fama and French wrote a paper on this, too. If somebody is making an error. You take the other side of that error, but not enough to arb it to zero. Because the early part of taking the other side makes you a decent expected return at low risk. But as you keep adding that to your portfolio. You’re closing the gap, and the expected return goes down, and the risk goes up, because you have to own more of it. So… If the world makes net errors, as Fama and French say, and I’m paraphrasing, unless errors miraculously balance each other. Prices will be set in a vote, in a dollar-weighted vote. So I find it very hard to believe that this environment has made our politics much worse, but a voting mechanism called the market has been immune to it. I could be cheap and point to the meme stocks. I think they are… a extreme mutated example of what I’m talking about. But I think it has… it has made… the idea of mispricings, even if they’re not all the time, occasional large mispricings from mob behavior, much more plausible to me.

Jon Hartley: There’s this question about quantities, right? So I think it’s very much… integrated into this, where, you know, right now, there’s, in academic finance, a big debate happening. And you mentioned this, about, you know, the roll quantities, and what do we mean by that? You know, it’s if you… hypothetically had, you know, a billion dollars on the sidelines in cash that just went into the stock market. What would the effect of that, you know, influx of cash of, say, $1 billion, would it… be, you know, a permanent increase of $5 billion, or a multiplier of five, and that’s kind of what the very behavioral folks like, Xavier Gabaix and Ralph Koijen argue in their new paper, it’s called The Inelastic Markets Hypothesis. Some people would argue, it’s a bit, less. You know, there was a paper in the 1980s By Andrei Shleifer that, you know, “Does The Demand Curve For Stocks Slope Down?” I sort of… I have a tongue-in-cheek paper called “The Elastic Markets Hypothesis” that argues it is somewhere in between, probably similar to yourself. But there is this question about, you know, what is the shape of the demand curve for assets? And, you know, in an efficient markets world, I think I would say it’s sort of perfectly elastic, very… Very horizontal, and in that sort of Fama world, or modern finance world, information was key, arbitrageurs were key.

Cliff Asness: The price is expected discounted cash flows, which doesn’t move with a trade.

Jon Hartley: Exactly, and it seems like this kind of, you know, say, very behavioral vision of very inelastic markets is almost going sort of pre-modern finance, where everything was about supply and demand, and I’m just curious what you think about you know, how quantities work. I mean, AQR, I’m sure, spends a lot of time thinking about market impact, of trading, transaction costs, you know, there’s this famous, you know, three-halves model, or, you know, quadratic model of market impact out there. I mean, how do you think about Sure. Is it a short-term thing and things revert, or is it a permanent thing in the same respect that Gabaix and Koijen argue there’s this 5X multiplier that’s kind of a permanent thing? How do you think about that?

Cliff Asness: Okay, it’s your fault again that this is a 9-part question. First, full disclosure, I think the world of Ralph Koijen, we gave him an award for The Inelastic Markets Hypothesis paper, because we used to give out an annual award, and he is actually the AQR Professor of Finance at the University of Chicago. So, with that said. I am… As you predicted, closer to you. on this. I… I don’t… my guess, and it really is a guess, you’re closer to the academic debate than I am. My guess is it comes out that markets are certainly not perfectly elastic. Gene Fama, when it comes to the efficient market hypothesis, something like, second week of class, he tells you markets are certainly not perfectly efficient. And the class gasps, because they’re at Gene Fama’s class at the University of Chicago, and he looks at them like. He doesn’t say this because he’s a very nice man, but he’s like, what are you, idiots? Perfection is a stupid hypothesis. The real world isn’t perfect. So I’m gonna guess some of it holds up? I’m gonna guess some of the critiques that are coming out, bring those results a little back, towards the middle. But one thing I stress is I make very little of my living based on market direction. I make it much more based on stock and other asset selection. We do macro also, but thinking about just stocks. Much more of my life is about 1,000 to 1,500 stocks long against 1,000 to 1,500 stocks short. the idea that that is highly inelastic is far less plausible than the market. We can debate the market. But the market has few close substitutes. And you can’t have… if you have few substitutes, it’s at least plausible to be somewhat inelastic. But if you have a lot of close substitutes, I think it gets very implausible, and individual stocks. Have tons of close… substitutes. So I have not seen… you might be more… you probably are more familiar with the literature, any paper claiming that individual stocks Say, a market-neutral trade. Are highly inelastic. Have you?

Jon Hartley: Well… I don’t… I think they claim that.

Cliff Asness: And it’s a Haddad paper that has something along this line.

Jon Hartley: there are some, that have tried to push the inelastic markets hypothesis thing beyond just sort of macro assets, which is, I think, the original sort of Raphael Koijen argument, that, that it may exist also in, in, at the stock level, but I’m skeptical of claims about either.

Cliff Asness: Yeah. But… and when it comes to market impact, first of all, it’s very real. You know, if you assume zero market impact, you way overestimate what you will make from any model or active process. But… when it comes to reversion, at the individual stock level, one stock against another, I think most of market impact is not permanent. Because again, being close substitutes, I don’t think it moves prices to the same extent. And it would be kind of weird if the prospects of one stock against another, were permanently altered because somebody put a trade on one day. You can imagine the market has to absorb that. A lot of people, which is not us, make their living from so-called statistical arbitrage. even going into the high-frequency trading world. And a lot of that is about what tends to trend and what tends to reverse at the short term. And again, this is not my world. I wrote a paper that was very close to state-of-the-art stat arb, in 1995, And I’ve been told this by stat arb people, and it’s my fifth story, you know, every fisherman has the one that got away, the big one. And I looked at it and said, doesn’t cover T-costs, and moved on. And, and… did, ultimately, if you kept that, it covered T-cost. I should have kept with that one. Big error. But I… I tend to think most of the market impact we look at is relatively short-term. And the jury, I think, is still out on market-wide market impact. Even there, I find it hard to believe you get a forever change in price.

Can it last longer? Is it hard to take the other… harder to take the other side? The plausibility of the Koijen and Gabaix story… actually, only has one co-author, so I shouldn’t say et al, but I can never pronounce the name right, so…

Jon Hartley: Gabaix, it’s.

Cliff Asness: Alright, alright.

Jon Hartley: French last name, yes.

Cliff Asness: We don’t mean this meanly, you’re a wonderful researcher. The plausibility of that story, when he says, how many people will take a market bet? We tend to run most things to a zero beta, so if somebody wants to go long extra stocks, we tend to… Mostly, I won’t say completely, mostly not be the people who take the other side of that. So then, you know, a lot of funds are wired to do that now.

Jon Hartley: So the notion that, that some of that.

Cliff Asness: Maybe, again, full permanency. I just instinctively find hard to believe, but the idea that that is far closer to permanent, that lasts much longer. I find that plausible. The market-wide argument, which I think is where most of this is occurring. Is mostly spectator sport for me. I don’t think it affects very much what we do. But I will be watching to see which one of you guys ends up winning.

Jon Hartley: well, yeah, well, I feel like there’s some similarities with the less efficient markets hypothesis and the elastic markets hypothesis, you know, things are… almost efficient, but not perfectly efficient, and, there, you know, there’s some things that are behavioral out there, but, but not a ton. So maybe we’ll, we’ll take that tag team for the win. Cliff, I really want to thank you for coming on. This has been an amazing conversation.

Cliff Asness: Oh, I really enjoyed it, Jon. These were fantastic questions, and thank you for having me.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Jay, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is Jay Bhattacharya, who is the current director of the National Institutes of Health, the NIH, and previously was Professor of Medicine, Economics, and Health Research Policy at Stanford University until March 2025, when he went emeritus to join the National Institutes of Health. Welcome, Jay, welcome back!

Jay Bhattacharya: Thanks, Jon. I still remember your help in packing up my office in the last days. Those were kind of sad and bittersweet in some ways.

Jon Hartley: Very special, and, missing seeing you walk around in your Stanford sweatshirt. You have to put a tie and jacket on for this new job. Well, great. I know you bought a bunch of new suits and ties, is my understanding, from your interview with Peter Robinson. It’s, maybe it’s a new, a new look, or, or a new permanent look. But, super excited, you know, to, to talk with you, and, you’ve since moved across the country, to Washington, D.C, and I know NIH is based in Bethesda, and you’re living in the DC area. I’m just curious, one, like, how’s this transition been? Can you explain to us a little bit about what NIH does? You know, I think a lot of people are familiar with how it funds a lot of scientific research, but can you explain to us, sort of at a more granular level, what NIH is doing, what’s going on in the halls of NIH on any given day?

Jay Bhattacharya: Sure. So, first, all these questions all at once, Jon, so let’s start with the first one. I mean, the transition’s been shocking. It’s been… it’s a very different job to be a professor than it is to be the director of the NIH, and, you know, just personally very dislocating. I’ve been a professor at Stanford for 25 years. almost 40 years at Stanford, if you include all the time I’ve done my education. So it was… it’s been… it’s been quite the transition, but it’s also been, I don’t… I mean, the NIH is an incredible organization. It’s more than a century old, and it’s, it… If you look at almost every single advance in biomedicine that we take for granted today, almost every single medicine that we use, all the, sort of, knowledge we have in biomedicine. I mean, there’s some role the NIH has played in that, and that is just to lead an institution with that incredible history is really quite humbling. And you know, it’s, Faced a lot of challenges in the past few years. In some ways, it’s funny that I am the NIH director, because, you know, one of the previous directors of the NIH, I mean, he sort of didn’t like me very much, I guess, at the time. We’ve since broken bread together.

Jon Hartley: Francis Collins.

Jay Bhattacharya: Francis Collins, yeah, and I think, you know, I was a big critic of the NIH during the pandemic. But at the same time, I have a great deal of admiration for the work of the NIH. I’ve been NIH-funded my entire career. I was a reviewer for NIH grants, for almost two decades. I love the NIH, and so the ability to, like, have it… have the ability to lead it and help it address the problems that it sort of created for itself during the pandemic, to restore public trust in it. And to have it actually lead it into the next century of innovation in biomedicine, that’s my job.

Jon Hartley: That’s terrific. So, I’m just curious, so one, you’ve laid out a vision for NIH. Tell us, what is your vision for NIH, and tell us, where did the Biden NIH go wrong?

Jay Bhattacharya: Okay, so, you know, I was thinking about how to do this job, and as I said, I view my job as sort of addressing like, a crisis in public trust in the NIH. There’s a Pew survey that’s, I think, 2024, found that 1 in 4 Americans think that scientists do not do… do not do things that are in the interest for the well-being of the people. I mean… just think about that. Like, the NIH relies on, essentially, broad public support. For forever, it’s been… it’s enjoyed pretty bipartisan support, both Democrats and Republicans. have supported it pretty substantially. In fact, I just saw a paper that suggests that Republicans have had, have supported it more than Democrats have, in terms of, like, votes for funding increases and all that over the last, two decades. And so what you have here is an institution that is broadly loved, and yet the pandemic had ruptured trust. In terms of, like, creating a vision for it, my view is that, I… I want the… I want the reforms, rather than focusing on what went wrong, I want the reforms of the NIH to restore the NIH to its path toward its mission, which is that, which is to do research, to support research that advances the health and longevity of the American people. Now, if you look at the state of American health, it’s not good, Jon. Right? In a dozen years, we’ve had no improvement in life expectancy in this country. That is absolutely shocking. I mean, this is something… when I was a grad student, I was… I remember reading about the rise in life expectancy in the United States and elsewhere. And just being… just marveled at it. When I was a… when I was a… when I was born, I was… I’m an Indian… a naturalized citizen, came to the U.S. when I was 3. I was born in India. I think the… the average life expectancy of an Indian boy born in 1968 was year I was born, is something like 48 or 50.

Jon Hartley: Wow.

Jay Bhattacharya: And, now I’m, like, 57. And so you… and what you saw is a steady rise in life expectancy in the developing world and the developed world, and I thought it would go on forever. now that we’re on the other end of a dozen years of no increase in life expectancy in the richest… one of the richest countries on Earth, the United States, you know we’re in a crisis. Right? And in a way, the NIH has not done its job. The job is to advance to support research that advances life expectancy and health. We have chronic disease crises all over the place that are, you know, just… I just look at the, the rates of obesity, of type 2 diabetes, of cancer incidents, of, of, you know, psychological maladies, including depression and anxiety at scale. You have, huge problems in the health status of our country. We are not a healthy country, Jon. And so, that’s the first element in my vision. I want the NIH to focus on research and to do research that reverses those trends. I think the America Healthy Again movement is an amazing opportunity for us to refocus the activities of the NIH toward things that actually do advance the health of the public. Now, you know, we’ve seen in the past dozen years huge advances in knowledge about genetics and a few other items in biomedicine. But if those don’t translate over to better health, then what purpose do they serve? Knowledge for knowledge’s sake is not worth funding, and it wouldn’t… it will not continue to gain… garner support of all the American people if that’s all it does. So, item one, we have to make America healthy again, and the NIH is going to play an enormously important part of that. Okay, got questions more, because I can go… like, I have 5 items.

Jon Hartley: Keep going, keep going.

Jay Bhattacharya: Item two. Item two. We have to solve a long-standing problem in biomedicine that’s been known. My colleague John Ioannidis a professor Stanford, who’s… I think, the most highly cited living scientist on Earth, right? Just an incredible man. And he, In 2005, wrote a paper with a title that goes something like, you know, Why Most Published Biomedical Scientific Papers Are Wrong. absolutely mind-blowing title for a paper. It’s 5 pages long. Any young graduate student looking to make a shock should emulate this paper, although you can’t take this, because he already thought of it. And it’s very convincing. Basically, the assertion is that science is hard. And the standards that we have for publishing in science do not guarantee that the things that are published are true. Worse, we have these, like. Publishing standards that guarantees that a large part of what we know to be true, generally null findings, will not get published. And so you have both problems, the false positive and false negatives problem in biomedical publishing, where large chunks of what’s published When independent teams finally ever get around to looking at it, don’t find the same thing. You know, I had a professor in medical school tell me, Jay, half of what you’re learning is just false. Jon, half of what you’re learning is just false. It’s true for econ as much as it is, I think, for biomedicine. And the reason why is because economics is hard, and medicine is hard. Science is hard. You can… as a scientist, you can convince yourself that you know the truth. you do your analyses, and you can, you know… but, very often, you make hidden assumptions that you didn’t realize you were making. There’s some, like, there’s, like, things you do to, like, that where you, where there’s unexamined assumptions that you, you have made, and you result… it results in… you’re convincing yourself you’re right. If you’re a good writer, you can be very convincing even to peer reviewers. And the statistical standards we use are not strong enough to guarantee that there won’t be good, you know, false ideas published with statistical evidence to suggest that they’re true. So, and then… and so what you have is, then, is a replication crisis caused by the fact that science is hard. You build on top of that a reward structure in science that says, if I can publish my papers in a top journal. then I am an excellent scientist who says true things about the world. I’ll climb the social status ladder. And so that creates incentives to write papers that are, I mean, sometimes fraudulent. Right? Because all that matters is you publish a top paper in a top journal. If you can get away with it, you might… you might… you might cut some corners here, cut some corners there.

Jon Hartley: Or P-hacking. There are the Francesca Gino and Danny Ariely sort of cases where it’s, like, you know, outright fraud, somebody actually, like, actually totally made up their data. But I guess there’s the more, pernicious, thing, which is, you know, just running… you know, a thousand regressions, and only reporting the one that worked, and… and then, you know, so it’s a peak hacking thing, but in reality, we know that, you know, that there’s some… just naturally, you know, some hypotheses are going to occasionally be, you know, a false positive from time to time. And so, if we end up just only publishing these sorts of you know, these p-hacked studies, you know, we end up being in a place where And we published things that sort of just accidentally happen to be true, and we just found those small instances, and we hunted them all down, even though they’re not really that robust.

Jay Bhattacharya: Yeah, well, so think about that. So, now, I have to say, when I look at the scope of John’s allegation, which is essentially that most of what’s published… much of what’s published is not true, and also the fraud… the potential for fraud, I actually think the first is much more important. I mean, they’re much more pervasive. Most scientists aren’t committing fraud. The vast majority are not committing fraud. We’re just telling ourselves that we think the world works a certain way, and we can convince ourselves, we publish it, but the world doesn’t work that way. Science is just hard. Now, they’re linked problems, because you can… you have a system that rewards publication in top journals as a measure of social status and advance in science. You’re going to get the fraud, but the harder problem is sifting between true and false when you publish publish. And the replication crisis is a symptom of that. When, I mean, like, I think there were, like, there’s been now dozens and dozens and dozens of, of, of demonstrations of this replication crisis. You know, in field after field after field, psychology probably was the first big, big field to have these crises, but now you’re seeing these crises in field after field after field in biomedicine, certainly. And, in fact, there’s… when developers… when drug developers sort of decide whether to invest in research in a certain area, they’ll… they’ll conduct their own private replication efforts. To check if the papers they’re relying on are true before they make the, you know, millions of dollars of investment in subsequent research. Right? In a sense, it’s a violation of the basic idea of how science operated once upon a time, which is on trust. If you have a paper that’s published. I would trust you that you’ve reported accurately what you’ve done, but if… if I can’t rely on that. then it makes the whole advance in science difficult. I mean, there’s enormous consequences for having a biomedical literature published that is not reliable. And I want to solve that problem. I want to solve that problem. And I think the NIH has it in its capacity to do so. In my view, there’s sort of two related things. One is, there’s no… there’s very little return to doing replication work. it’s often something you hand off to a grad student to do to, like, you know, as a practice exercise. You can’t get it published anywhere, because it’s seen as non-original. So that’s one problem, right? Almost no returns to actually doing replication and publicizing it. And then the second problem is that the, you never get any return for doing the kinds of pro-social things as a scientist that allow replication to happen. In fact, it’s the other way. If someone approaches me and says, Jay, I want to replicate your paper from 19… 87 or whatever. Actually, 1996 or whatever, that made my first paper. Well, I’m gonna, I’m gonna say, well, why do you hate me, Jon? Why, what’s, what’s wrong with, with, with me? Rather than what I should be thinking, which is, it’s a great honor that you’re revisiting my, not-very-seminal work from 1996. Like, it gives it more importance, right? And in fact, that act of pro-social action, like, I make my data publicly available, I make my code publicly available, I… describe my, sort of, protocols in a way so that you don’t even have to approach me. You can just try to replicate it yourself just based on what I’ve written. Those are all measurable things That are good for science. Even if you don’t do replication. Right? They’re activities of science that allow replication to happen, and yet we don’t reward it. We measure… I mean, I’m sure, you know, you’ve gone to Google Scholar, you can look and see what Google Scholar… they have measures like the number of citations that you have. or the number of papers that you have, or the H-index, God forbid. You know, as an aside, the H-index is a terrible measure of scientific productivity. It’s like, it’s, you know, you know how it works, right? It’s… you gotta have… an H index of K means you have at least K papers with K citations each.

Jon Hartley: Right, so…

Jay Bhattacharya: So, imagine Watson and Crick, Watson Crick and James Watson, they published their one big, one paper in their entire life, which is the double helix structure of DNA. It gets 1 million citations, fundamentally transforms how you think about… everyone thinks about biology. It’s a… it’s a… if you just had that one paper in your life, you’d think you’d have a successful scientific career, right?

Jon Hartley: Right, but an H-index of 1, I guess, in this.

Jay Bhattacharya: Yes, because in this hypothetical, they don’t have a second paper with at least two citations, so they… but they do have one paper with at least one citation. A million citations, mind you, but one. Their H index is one. And if… same thing with, like, they’d have the same age index as someone with a million papers. each with one citation in the Journal of Irreproducible Results or something, and that… I mean, that also would have an H-index of 1. It’s a terrible measure. But you’ll notice that those measures, what they’re actually measuring, they’re measuring volume, how many papers you have, and influence. Volume and influence. Are those the only real measures of… Of productivity for scientists we want. It’s like measuring a baseball player by, you know, stolen bases, but you don’t also have caught stealings.

Jon Hartley: Yeah.

Jay Bhattacharya: or home runs, but you also have strikeouts, right? You need to have a more complete measure of set of things that we want, and if you measure it, as economists all know, if we measure it. will reward it, we can reward it. You can change cultures around measurement. Right, let’s stick with… oh, sorry, Jon, go ahead.

Jon Hartley: No, I was just saying, you know, and I wonder if this sort of shift… I don’t know, maybe there’s a reason for it in the sense that, like, you know, there are just fewer low-hanging fruit scientific ideas nowadays, you know, there’s this whole sort of idea that, you know, productivity is slowing down because we’re running out of good ideas, and maybe at some level in academia, people are sort of running out of ideas, so it’s, you know, the last fewer Nobel Prizes given out for, you know, these incredible, you know, singular achievements, whether it’s, you know, double helix DNA, or… Black-Scholes, you know, there’s just, like, concrete single papers, right? Now it’s, you know, a career, and it’s a literature, or changing a literature, you know, it’s, you know, the Acemoglu-Johnson-Robinson paper, you know, a lot of people were like, well, you know, the papers aren’t really replicable, but But it changed the direction of the literature, and that it got people using… it was the first paper to use, you know, applied tools with understanding whether an institution was better for growth. And economic growth is a big question, and I think, you know, Daron’s brilliant, I think, you know, it’s a brilliant research team, but it’s interesting how it’s… maybe this is all part of a trend that people are trying to really promote themselves when… You know, there really aren’t as many very concrete findings as maybe there were, say, a couple generations ago.

Jay Bhattacharya: I just don’t agree with that, frankly. I don’t… actually, it’s part of a third part of my vision. I don’t believe that the world is bereft of opportunities for ideas that advance fundamentally our understanding of the way the world works. I mean, if I look at the way… our knowledge of the way the world works, the physical world works, I mean, I think we’re still in our infancy of our understanding of it. Right? There’s vast fields of knowledge still to be gained, vast ways of thinking that we just haven’t discovered yet. What we have is an incentives problem, not an opportunities problem, in my view. that we haven’t given people enough incentives. By the way, that’s my third part of my vision, to, like, get… to transform biomedicine in a way so that people want to find those ideas, those new ideas. We’ve become stuck in a rut in ways, sort of the Peter Thiel stagnation kind of idea. And I want to fix that. Before we move off replication, though, I just want to close the loop on replication. If you solve those two… those problems, you reward people. Who want to do replication, give them a place to publish it, and you measure pro-social activities that encourage replication by scientists, you’re gonna have replication essentially become the standard of truth in science. It’s an epistemological revolution. Rather than saying, is it published in the QJE, or the AER, or is it published in New England Journal of Medicine, Biomedicine, or Cell, or Nature, as the standard of whether some idea is true or false. Instead, what become… will, is… what will become the standard of truth is. Is, is the idea replicated? Are other people, when they look at the same thing, do they find the same thing as you do? And is it important? Obviously, we’ll remain an important part of this, but, like, is… if you have important ideas that are replicated, those ideas then have the… people will have more confidence that they’re true. It won’t just be that you’re published in a top journal. Right now, what we have is authority-based measures of truth. An epistemological revolution with replication says it should be replication that is the standard of truth. Imagine you search in biomedicines, PubMed, you search PubMed, you get a paper that comes up, and you have a replication button. You click the replication button, and all the relevant replication efforts for the paper pop up alongside it with some AI summary of what it says, and with links to each paper of replication effort. So you can assess yourself.

Jon Hartley: That won’t…

Jay Bhattacharya: Other than if it’s published in a top journal. Even top journal papers won’t necessarily replicate.

Jon Hartley: Absolutely. Well, I’m totally with you that we need replication, and I’ve written some papers on how much p-hacking there are, and… certain RCTs that, and to what degree preregistration, for example, improves or reduces the amount of p-hacking. But I’m just curious, like, what are the tools that we can use to properly create these incentives? Like, are we gonna have, like. I don’t know, more replication journals, or are we gonna have… I don’t know, more meta-science, you know, type studies being rewarded, or… like, I’m just curious in the sense that, I think there’s still this problem, which is, you know, we have this, like, 10-year system that generally is rewarding people For these, you know, papers that, you know, it takes time to write a paper, it takes time to replicate a paper. that, at some level, like, it’s still the, you know, you have these tyrannies of whatever the metrics are. In economics, it’s top 5, how many top 5 publications you have, you, maybe you need 5 or so to get tenure in a top department. Similar with, you know, finance, there’s top 3. clear top three journals, like, how do you break the tyranny of the top 5, or how do you get the top five to actually care about, replication, and how do you get, people to be incentivized to do replications to the point where that could actually help someone get tenure? I’m curious…

Jay Bhattacharya: Let me, let me, let me just stick to biomedicine, because that’s the job at the NIH. Fixing economics is another, is another question. probably beyond me, Jon, frankly. In biomedicine, the NIH has tremendous power to solve this problem. So first, you, you, we, we, we. We can and will start awarding researchers large grants to do independent replication. That’ll be their job. We’ll find the other… the new, the new Jon and Eddie’s of the world, and have them compete for grants, and give them grants, large grants. Those are signals to their institutions that these are excellent scientists, and they’ll start to gain promotion and tenure. Whereas now they don’t get it, just because simply the NIH awarding a large grant is a strong signal of this is an excellent scientist. Right? Second, the NIH can stand up a replication journal. In fact, we’ll do that. We already have the Journal of the National Cancer Institute, it’s not something that we’re not used to doing. And essentially, we’ll have, like, a repository where you can put your replication work. And we can link it to PubMed, which is another NIH product, where you can do the kind of replication button in the search results and say, does this paper replicate? And get that… get that summary. That’s… those are all just… I think I can just, like, you know, this is something I can just have the NIH do as director, and in fact, I’m going to have the NIH do as director. We’ll have to stand up… we’re working on standing up this new replication office that, we’re inside the office as director, where it’ll coordinate those replication activities across all the NIH. And then third.

Jon Hartley: This is the Office of Research Economics, Planning and Analysis, or OREPA, is that…

Jay Bhattacharya: Yeah, that’s… well, that’s the new… that’s the… well, that’s the current acronym for the… for the… for the OREPA for the… for the… for the, for the office, but that… but that would be its activity, to sort of, coordinate the kind of replication activities With the aim of inducing a culture change, within all of… and, you know, essentially an epistemological revolution is what it’s really aiming at. And then, the third thing is that we can start to develop metrics. There’s a whole field of science of science. My colleague and former student, Mikko Packalen, and I have written a whole bunch of papers together. using the method of methods of economic econometric methods applied to science. And, you know, there are people like Pierre Azoulay, Bruce Weinberg, Donna Ginther, a whole host of, like, fantastic economists who’ve devoted their attention to this. To this field. We can… we can develop metrics, those pro-social… those metrics, we can expand the metrics so that we… right now, we are right… are in a kind of, Okay, you’re too young for this, Jon, but, like, once upon a time, there was a fantastic sabermetrician. Sabremetrics is, like, the science of baseball research. And there was a guy named Bill James.

Jon Hartley: I know Bill James. I met… I used to work… I spent a year doing football analysts for the Dallas Cowboys, long story

Jay Bhattacharya: What? Are you serious? Okay, that’s fantastic.

Jon Hartley: They’re still going, I think.

Jay Bhattacharya: He is, he’s still… I think he works with Red Sox? I’m not sure.

Jon Hartley: That’s right, or was for a long time. He might have parted ways in recent years, I think.

Jay Bhattacharya: Well, he… I… in the 1980s, I used to get his baseball abstracts. Apparently, he was, like, a night watchman. He would sit there writing, books, cranky books about how no one understood baseball as, because they didn’t have the right set of statistics. And I would read and go, like, man, he’s right! So, like, he had this, like, he had this, like. point, which anyone who knows baseball realizes very quickly, that a baseball hitter, their main job is to not get out. And yet, the baseball… the standard baseball statistics back then, didn’t value walks. Well, if you walk, if you get a walk, you draw four balls, and you get to first base or whatever, that is… that means you didn’t get out. that’s a good baseball player, right? That has the ability to draw walks. So they get these, like, statistics where he would, like, rank baseball, re-rank them based on a broader set of productivity metrics, and very different players would end up being the top player. Like, Wade Boggs turned out to be a big hero of his, and mine, because he was a Red Sox fan. I’m a Red Sox fan. So… so… we went from that to the Moneyball, remember that movie? It was about the Oakland A’s who grabbed all of these statistics, transformed how they made personnel decisions, and became a small market team that would get, you know. That would win a lot of games every year, as a result of taking advantage of these, like, new statistical methods. We are right now, in science, we are… we are in the Bill James age. There are all these science-of-science kind of ideas floating around with metrics that are… that are burbling around… burbling up, but we are not in the Moneyball age. We have to start measuring productivity Using the kind of things we actually want scientists to do. Right? Pro-social behavior by scientists, like, do you share… what fraction of your papers have you shared your data? What fraction of your papers have you… have you, shared your code? That would be in economics. In biomedicine, it might be tissue samples. It might be, it might be, like, how… How well do you write your method sections so that people can… don’t have to come and ask you for, how did you do it, what your secret sauce was, and they can just replicate it directly just based on the description. I mean, if you have those metrics, people will start to do it. And then if you have this epistemological revolution where what matters is, you know, are your ideas replicable? Do you have important ideas that actually are replicated? then what will happen is, all the incentives for fraud will drop away. It won’t matter how many top 5 papers you have, what’ll matter is, are the ideas you have, whether they’re published in the top 5 papers, important, and are they replicated? Right? It just changes the whole incentive structure of science, and I think the NIH can, at least for biomedicine, we can accomplish this.

Jon Hartley: Yeah, absolutely. Well, I guess one thing, you know, for example, I think that would be super interesting to look at, and maybe something that you’re already… you’re doing, is… you know, we don’t, or the public, at least, hasn’t really… and researchers outside the NIH, haven’t really had the data that we need, for example, to measure, like, how effective NIH grants are. And, like, to do that, I think you need, at least, I guess, from an econometric sort of approach, and methodological approach, you know, you’d need you know, the applications, you know, for the NIH grants, you know, not just the successful ones, but those that have been turned away and… or rejected. And so, you know, you could probably do, you know, some sort of analysis of, you know, if there was some ranking, you know, you could sort of look at the marginal ones that were, you know, just accepted, the ones that weren’t, and…

Jay Bhattacharya: No, we’re gonna have that. That’s what this office, this new office I’m developing is gonna do. is going to have… it’s gonna have, we’ll have great econometricians in there. We’ll make the data… I mean, there are some restrictions, because you don’t want, scientists to send their proposals in and fear that they’re gonna… the idea will get stolen, so… so there’ll be some protections, but we’ll make the… to the extent that that’s feasible, those data and raw data available, so a broader set of scientists can start to make their own metrics as well. I mean, I want this field to just blossom, because it’s the key to solving all the crazy instances of scientific fraud. you ask yourself, how come it’s happening? Like, why are these, like, prominent people being found to have committed fraud? It’s not… fundamentally a moral issue. It’s not… how do I put this? I said that wrong. It’s not fundamentally an issue of individual moral failure, repeated individual moral failure. It’s a system failure. We have created the wrong incentives in science. If we create a different set of incentives around replication, all the incentives to commit fraud will go away, because why would you commit fraud if you’re not going to get credit for it? Who cares if you’re publishing top journal? If you committed fraud, then no one’s going to be able to replicate your work. You don’t get any credit for it.

Jon Hartley: Okay.

Jay Bhattacharya: How about getting back to truth? I mean, that’s… Yeah, it’s an epistemological rubber.

Jon Hartley: That has to be, you know, if truth isn’t, you know, centric, you know, there has to be, you know, truth before. justice, or, or, you know, other concepts, you know, for whatever reason why people get into doing research, and, and, you know, maybe people want to help, or, or, you know, maybe, you know, there’s a lot of researchers that maybe have some sort of activist. Intentions, you know, to shape policy, or to shape. I don’t know, you know, their field, or some sort of policy, or some sort of… I don’t know, commercializing some sort of set of drugs, or wherever have you, whatever those incentives are.

Jay Bhattacharya: you know, truth has to come before… Like, once you… once you establish that some idea is… is… has some likelihood of being true, then you can start to discuss is it important for public policy? Is it important for development of drugs? Is it important for changing how patients should behave? Or what, you know, advice we give, whatever, right? That truth is a necessary condition for the effectiveness of science. And it’s… I mean, that’s why that’s the second part of my vision. I want to solve this replication crisis. It’s because it’s fundamental. We think of science as a hugely productive thing, but it’s only productive to the extent that it actually encourages people to have incentives to find true things. True things about the way the physical world works.

Jon Hartley: Absolutely.

Jay Bhattacharya: Okay. Let’s go to my third part, third point. We spent a long time on this one. This was… this is a… but this was important, right?

Jon Hartley: Replication crisis is a big one.

Jay Bhattacharya: Okay, so you’ve already set up the third one, which is, the stagnation problem. Right, so a few years back, Chad Jones and some of his colleagues, fantastic economists at Stanford, of course, wrote a paper where he calculated, the number of papers in In, in, in cancer, in breast cancer, about breast cancer, per advance in In, in survival for breast cancer patients. Right? And what you find is, like, you know, if you go back to the 50s, 60s. The number of papers written per improvement in survival of breast cancer patients was actually pretty low. And then… and then there’s, like, this flattening of the curve, where now… now, every single Sort of month of life expectancy increase for cancer… for breast cancer patients involves literally, you know, thousands and thousands of papers. Per dollar we spend on biomedicine, we’re getting less advanced than we used to get. Right? And you laid it out well, actually. You said, well, what if there aren’t enough… what if we’ve run through all the easy ideas? And we’re just… we’re just now on the flat of the curve, into perpetuity, y’all, we’re never going to make any new advances, because everything is just really, really hard to make any advances. You know, I… I was reading the other day, the… a physicist, very famous physicist, empirical physicist from the turn of the 19th century, who said exactly that about physics. You know, he’d seen an enormous generation of tremendous advance in physics, where electromagnetism had been sort of worked out. You know, of course, there was Isaac Newton in mechanics, had been worked out. Huge, huge advances in physics. And he said, well, what if we’re done with physics? And all the rest is just footnotes. You know, the finding the… the 500th, decimal in Planck’s constant or something, right? And, you know, of course, just a few years after that, there were enormous revolutions in physics. You know, the relativity, and the quantum theory, and, like, just huge advances. You don’t know that… you don’t know that those advances around the bend unless you keep knocking at the door. You keep trying new ideas out. And let’s just bring it back to economics. You need… you create a, incentive structure where those new ideas are allowed to be tried out.

Jon Hartley: I think, you know, to complete your analogy, I mean, it’s… I think when… I believe George Bernard Shaw and, Einstein won the Nobel Prize in the same year. or were at the same Nobel Prize gala, and I believe George Bernard Shaw, you know, was congratulating Einstein and overturning Newton, and he said, you know, he looked forward to the day when, you know, someone overturns what, you know, what Einstein’s, you know, thought of the day was. So, I mean, you know, I guess it’s knocking at that door.

Jay Bhattacharya: Yeah, again, I’ll sleep aside physics, because I don’t know anything about physics, but, like, but let’s just stay with this. Say with biomedicine. I did some work with Mikko Packlin a few years back, where we looked at, how old are the ideas in the published biomedical literature? How old are the newest ideas, supported by the NIH? Okay, so first of all, how do you measure how old ideas are? It’s actually weirdly simple. So you just… you take PubMed, you take all of the papers in PubMed, which is all of them in biomedicine, that were published in 1940, You, then do the same thing in 1941, get rid of all the synonyms, and then subtract off all the 1940 ideas, and what you’re left with are the new ideas that are… that were introduced into medicine in 1941. just comes straight out of some complicated, like, large-scale computer analysis. Easiest buy. And then you do it in 42, 43, 44, 45, you have… what you have is a history of biomedicine. Every year, you see all the new ideas that were introduced in that year. You go back to the papers and ask, how old are the newest ideas in each paper? How old are the newest ideas in each paper, right? So a paper that’s on the cutting edge will be working on ideas that are zero year old at the time that the paper is published. Papers that are working on older ideas, or will have, you know, 10, 15 years old as the newest idea. Right? Now, if you go back and ask. What… how old were the ideas for papers that were supported by the NIH in the 1980s? Well, they were working… they were working… they were… those papers were working on ideas that were 0, 1, 2 years old, like, really the bleeding edge. If you look at the 2010s, you know, what you see is Papers that are working on ideas that are 7, 8 years old. We’ve become way too small-C conservative in biomedicine, like, too… way too afraid to, like, try new ideas out. in a sense, we punish failure too much. It’s very different than Silicon Valley, right? So, in Silicon Valley. You have, like. you’re a portfolio manager, you have 50 projects, you’ve, like, done all your… you got your Stanford MBA, so you know you need to diversify the portfolio. And the key thing is, it doesn’t matter if the 49 of those projects fail. If the 50th is like Google or something, that’s a very successful portfolio. In biomedicine, and at the NIH in particular. It’s become much more conservative in the sense of You know, if… if… an institute director at the NIH funds a portfolio of 50 projects, and 49 of them fail. And the 50th solves type 2 diabetes or something. That’s… often you’re gonna get… people are gonna complain that, why do they fund 49 projects that failed? that’s a problem. Like, it’s, it’s… so the result of that kind of reward structure, and I remember, like, being told this very early on in my research careers, Jay, be sure to hit the bunt singles. You can swing for the fences every once in a while, but you gotta hit the bunt singles. Get a lot of papers out. and, the us- the problem is that, Is that we need people to be willing to… Try new ideas out, to invest in them, to take risks on them. I mean, Silicon Valley doesn’t punish people who fail all that much, right? If they fail productively, they’ll get another chance.

Jon Hartley: We have limited liability and all these sorts of things that, give you this.

Jay Bhattacharya: Yeah, but we invite them.

Jon Hartley: Nice, sir.

Jay Bhattacharya: It’s the other way, Jon. We… we, like, if you, if you… your postdoc, if you don’t get a paper and cell, you’re done. You’re not going to get that next postdoc, right? It’s… it’s… we punish failure too much in biomedicine, and we… we essentially don’t allow new research… early career researchers, who are the font of new ideas, enough ability to try their new ideas out when they’re still young. I mean, that’s new, by the way, by the way. In the 1980s, we funded researchers with large grants. Their first large grant would be in their mid-30s, and now it’s in their mid-40s. We basically make it too difficult to establish yourself as a career in biomedicine nowadays than before. And I think that’s the root of the stagnation problem that you saw that Chad Jones sort of documented so well. Chad Jones and his colleagues documented so well. I think, who else? There’s another Stanford economist, who’s on the paper, but anyways, but the point is that, that stagnation problem That stagnation problem is, again, an incentive problem. And we have to change the incentives in how we fund research To allow that kind of, of innovation to actually happen.

Jon Hartley: So it’s more like, how do you make NIH kind of like a venture capital or VC accelerator, in a sense?

Jay Bhattacharya: Yeah, exactly, exactly. And so, okay, so this is something I just recently been working on, and I think this is… I don’t know if this is the only innovation we need to do this, but it, I think it’s part of it. We have these… at the NIH, the way it’s structured, there are 27 institutes and centers and offices, each of which are, like, focus… many of which are focused on disease areas or whatnot. And the head of it, as an institute director, is a world-class scientist. And they’re responsible for the portfolio of investments in their area that the NIH makes. The emphasis has been many of those institutes is to… we have a great peer review system where you send in a proposal, we’ll get it scored, and what they’ll do is they’ll look at the top nth percentile of, you know, 10% of scored grants, and then fund those grants. Because we have a great… this peer review system that’s with, again, with world-class scientists doing the peer review, evaluating each grant. The problem is, and I’ve been a peer reviewer, I can tell you, the emphasis is on methods. It’s so easy to say to a new idea, while no one’s tried that, it can’t work. Really, really easy to do that. Kill a new idea. They’re supposed to score innovation, and they do, but they don’t really emphasize innovation in deciding what gets the best scores. And also, the peer review will tend to focus on areas that are currently hot, rather than things that are promising, but not yet hot. Right? The institutes have their own strategic plans that they put up every few years of, like, where the most promising ideas there are in their fields. So what I’ve done is a change in how the institutes are gonna choose their grants. They’ll still have peer review, you’ll still have the scientific scores and peer review, absolutely the fundamental bedrock of how science… the proposal is going to be evaluated. But, suppose there’s 10 grants that are basically looking at the same idea, and that are part of the strategic plan, and, you know, basically one or two grants that didn’t score quite as well, because the peer reviewers didn’t really know about the idea, didn’t… it was a new idea. The institution directors will have the capacity to pick their portfolio to match the strategic plan. Maybe they’ll take one or two grants from the 10 that’s in the hot area, and one or two grants from the less hot area, but, like, very promising area. And they’re going to be evaluated not based on every single individual grant working, but rather the portfolio as a whole. Does it actually advance knowledge in ways that improve health of the population? Right? Does it make America healthy again? Does it change biomedicine? Does it… does it reduce fundamental changes in basic science that advance biomedical knowledge? Things like that. for the portfolio as a whole, rather than sort of grant by grant. We gotta punish failure less. We also have to think of ways to, like, advance the careers of early care researchers much more. And that’s… that stuff I’m also, I think we can do much better than we have.

Jon Hartley: Absolutely. Well, it’s funny, you know, I think you and Peter Thiel were in the same class, or maybe a year apart from each other at Stanford, so given how much time you spent at Stanford. Both in, I think, all your schooling and many years as a professor, I think, you probably understand the VC mentality, probably, better than anyone else.

Jay Bhattacharya: Peter and I were friends, I mean, I think I met him when I was 19. He was, you know, he founded The Stanford Review. He was my dorm. He was poor then, so at one point, I think I lent him pizza money. I think he still owes me. Peter, if you’re listening, you don’t have to pay me back, I forgive the debt.

Jon Hartley: Gotta think about how much interest there could be there, you know, or what the return is on that.

Jay Bhattacharya: No, we were friends, we are friends now still. But he, but yeah, I mean, he, I think has been the, probably the most prominent person, articulating this idea about stagnation. scientific stagnation, and decrying it, calling for changes in how we think about science so that we can get more real advances. And I think he’s right. I think… but I don’t think the problem is any lack of opportunities in science. I think the ideas are there. We just need to set the incentives for people to find them.

Jon Hartley: That’s… it’s fascinating. I mean, it’s been a… it’s amazing, you know, for many years, until, I think, just recently, maybe the past couple years since sort of the dawn of all these generative AI tools going online, you know, that… there was kind of a refrain for, like, 10 years during the 2010s and that period, you know, we had these books, like, by, Robert Gordon in economics, you know, the rise and fall of economic growth. And, The Rise and Fall of American Economic Growth, I think is the title. And, you know, just this idea, you know, that we’re running out of ideas, and that’s why we’re becoming less, productive, and, you know, we had these great ideas in the early 20th century, whether it was commercial air travel, you know, air conditioning, you know, which allows people to work in much warmer climates. Huge for the developing world and, you know, the southern United States. You had all these, you know, you had all these household appliances. you know, much later, I mean, you had the automobile in the early 20th century, and the internet at the close of the 20th century, and all these things, it’s kind of like, I guess, what a lot of people look back on and say, you know, in the first maybe couple decades of the 21st century is you know, oh, you know, compared to all those incredible innovations, all we got were, you know, social media apps, and I mean, those might be, you know, some sort of a negative productivity innovation, perhaps. But, you know, where are all these, Incredible, you know, innovations that are gonna increase productivity. And it’s interesting now, you know, we obviously had, you know, the mobile phones and smartphones and so forth. But, you know, which allows us to do certain things. But I think, you know, the release of generative AI tools, I think the conversation around that has changed, at least, and it’s more, sort of, I guess, people are open to this idea that generative AI tools and sort of their successors, or innovative successors could potentially, you know, be hugely transformative. I’m curious if you have any thoughts on, I guess, generative AI and how it intersects with NIH, what NIH is funding, and thinking about.

Jay Bhattacharya: I mean, I think AI tools are probably a counterexample to the assertion you’re making about the assertion, the hypothesis you’re putting forward about the slowdown in ideas. I mean, that’s an unexpected leap in the ability of machines to look like they’re reasoning, although I don’t think they’re actually reasoning, but that’s… but they are really a big step forward. And I think that, in health, it’s gonna transform the way we, do drug discovery. It already has, like, you know, AlphaFold and its ability to predict protein structures has has just sort of pushed drug development leaps and bounds forward. It’s gonna change the way that, I mean, just something as mundane as, like, you know, you go to a doctor, and the doctor’s staring at the screen the whole time rather than looking at you. Because they’re writing in all the billing codes that need to bill. imagine AI sitting there listening, and then filling in all the records for the billing, and then, of course, the doctor can look and just very quickly do that afterwards. Instead, they spend their time looking at you. Right? Imagine a tool that helps the doctor make sure that they’ve thought through every single diagnosis. They give suggestions to radiologists or cardiologists, where they compare against other patients that are similar to you. You know, you’re still gonna need doctors, you still need the human touch. When people are sick, they really do need human beings to, like, be there caring for them, especially smart human beings that are, like, thinking about what their problems are in concrete ways. But AI has the possibility of transforming so much in biomedicine. And we are absolutely at the nation investing in that. if we… you know, maybe I’m wrong. Maybe they won’t be as productive as I think it will be, but in my view, it’s already proved to be quite productive, and it will be… I think if we invest more, we’ll be… we’ll think of better ways to make sure that it… to make that productivity happen, but also to make sure that it doesn’t hallucinate and hurt patients and things like that.

Jon Hartley: That’s fascinating. Okay, I think that was number 4, is that right?

Jay Bhattacharya: That was 3, actually. That’s still… oh, that’s still under 3, the stagnation. Let me do 4. I’m almost done, I promise, Jon. 4 is, Four is, we have to make sure that we don’t harm people or take existential risks on behalf of the human populations in the research we do. Okay, let me motivate this. this is gonna be controversial to some people, not controversial to others. It is quite possible that COVID was caused by scientific research that we did, that we supported. that the Chinese did… conducted, that we… that we were part of. There was a… Big debate. In the, in the 2000, teens. over a research paradigm called gain-of-function research, dangerous gain-of-function research. Let me tell you the research paradigm. The idea was that we could prevent all pandemics. It’s a very utopian idea. What you do is… here’s what you do. You fund research to go out into the wild places. Find the viruses, find the pathogens, b

ring them back to city centers. Manipulate them so that they’re more transmissible among humans, Only in the petri dish. The reason you do that is that if you can distinguish between pathogens you bring back from the wild that are very easily manipulable so that they become only a few evolutionary steps to make the leap into human populations, versus other pathogens that are very evolutionarily far away from being able to make that leap. Well, then you can focus on the pathogens that are likely to make the… that are close in evolutionary space. Prepare vaccines in advance, prepare all this other stuff in advance. So that when it makes the leap, you’re ready. That’s the paradigm. The first time someone actually accomplish this, of taking… it was avian flu in 2010 and 11, making it more transmissible. This is NIH-funded research. The scientific community said, this is ridiculous, this is too dangerous. You have a chance, if there’s a lab leak, of causing a massive pandemic that will kill millions of people, we shouldn’t be doing this kind of research. Right? Let’s go back to physics. Enrico Fermi, when he launched the nuclear age, what he did is he did a calculation, the first nuclear chain reaction on the squash court at the University of Chicago, of all places. He did a calculation of, will this chain reaction consume the Earth, burn the Earth, or can we make it stop if we want to? And the calculation, before you did this experiment was that the probability of consuming the Earth was zero. And so then he started… then he did the experiment that would launch the nuclear age. We need to do that with biomedicine. We need… and President Trump’s executive order on danger of getting function actually allows us to have that kind of risk-based paradigm for thinking about regulating biomedicine. Like, the vast bi… the majority of biomedical research has no risk of causing this kind of pandemic, right? So… but we need a regulatory structure that gives incentives to scientists and institutions To, to subject any experiment that does have the potential for catastrophic risk to be subject to this regulation, where other independent eyes can decide. Should we do this work? A scientist alone An institutional loan should not be independently be able to make decisions that risk vast harm to literally billions of people, simply for scientific curiosity or other reasons. And so that… the gain-of-function executive order by President Trump essentially allows us to have a regulatory framework that will that will reduce that risk to near zero. And the White House is still working on that, we’re still… when we’re helping, this is something I think is tremendously important. It’s important to me because the way you restore trust is by telling people, we’re working on your behalf. We’re not trying to do crazy things that will risk your family’s health and well-being. Quite the opposite. And so, to me, this kind of, sort of, attention to biosecurity… sort of, attention to, like, the sort of the riskiness of biomedical research is very, very important. It’s a necessary condition for restoring trust.

Jon Hartley: Are there any efforts to ensure that that’s happening, say. In China, you know, obviously there’s, you know. they may not be as, you know, as careful as the U.S. with these sorts of things. I mean, obviously, there’s only so much you can do from, like, a diplomatic standpoint in China that’s… you know, has broken many agreements, and they, you know, they don’t respect, U.S. intellectual property. I mean, there’s all sorts of issues, but I guess is that… obviously, human rights is kind of, I think. has been front and center with a lot of these conversations with China, along with, sort of, defense issues, Taiwan, and so forth. But have these sorts of conversations come up in any of those sorts of discussions? I also know, like, AI often, one of the criticisms that I hear about, sort of, unregulated AI is that, while, you know, there’s some possibility that you know, someone could use a chatbot tool in, say, a random foreign country to help build some sort of a bioweapon that they could use against the United States or peaceful people. Do either of those things concern you, or… They do, actually.

Jay Bhattacharya: Absolutely concerned me. I mean, I think, President Trump has set a huge example for the whole world. By taking this kind of dangerous gain-of-function seriously and regulating it so that we essentially make a commitment not to do it, we’re telling the whole world, you shouldn’t be doing it either. You shouldn’t be taking risks that risk the harm to every human being on the planet just for scientific curiosity, or whatever gains you think you’re going to get from it. even if it’s… let’s say it’s a bio… you think you’re doing bioweapons research with it, or whatever, right? That’s banned by the 1973 Bioweapons Convention, but let’s say you’re doing… really, there’s no way to guarantee that you won’t harm your own population in the conduct of that research. We kind of need a strengthened bioweapons convention, something that… a gain-of-functions convention, essentially, a dangerous gain-of-function convention, that’s international in scope, that says this is not research that’s worth doing, it’s not going to help anybody, it’s not in any country’s interest to do it. Because it, it’s, it’s research that if you cause catastrophic harm to human populations, you will also harm your own populations in doing it. There’s no nationalistic interest in doing it. This is the kind of thing that really should be subject to international treaties. But I think it’s really amazing that President Trump is the one that actually took this step. That said, look, we’re going to unilaterally not do this because it’s not worth… it’s not in American interest to do it. It’s frankly not in anybody’s interest to do this kind of dangerous research.

Jon Hartley: Absolutely. No, it’s, yeah, being 5 years up from COVID, it’s still, still looms large in the memories of many, to the least. Okay, so number 5.

Jay Bhattacharya: The last one, and I promise to let you go, Jon. You probably had no idea, I’d keep you so long, but the number 5 is free speech and academic freedom. And, Jon, you probably know this. Actually, we talked about this in our previous podcast that we did together. COVID was a very difficult time for scientific… scientists to express their ideas, especially if they disagreed with, sort of, the predominant pro-lockdown, pro-mask mandate, pro-vax mandate, kind of, kind of ideas. And, it made scientific progress during the COVID era much, much harder than it should have been. Science depends on free speech just to thrive, right? If you disagree with me, Jon, you absolutely should be able to say that you disagree with me, and you explain why. And, you know, I’ve had many situations… I’ve taught at Stanford for 25 years. I had so many situations, some of my proudest moments, when a student would tell me I’m wrong, and then they would be right, and we would write a paper together. You know, hiding the fact that I was wrong before, of course, suffered from the world, but that kind of open correction of each other is the heart and soul of science. And restrictions on free speech and academic freedom are anathema to scientific progress. They’re an absolutely necessary step required for progress in science. And the NIH needs to be a catalyst for this kind of free speech throughout the country. At the NIH itself, when I came in, I found out that they had a policy for… that we have a whole bunch of intramural scientists, amazing biologists who do a lot… a whole host of different kind of research internally inside the NIH. Publish it in scientific literature. I found out there was a policy in many of these institutes where the scientists themselves had to seek permission Substantive permission from their supervisors before they were allowed to send their papers out for review by other… by, you know, journals. That’s not academic freedom. That… I mean, that… you can’t make science advances… advance if you have that… those kinds of restrictions where you’re worried about what your supervisors think about your science. I mean, obviously, you want good science, but you don’t… I mean, you don’t want your supervisors to tell you, well, I don’t like this result, you can’t send it out. So I put in a policy now where any intramural researcher can just send their paper out. For scientific review without asking any permission. I fully expect there will be papers published at the NIH that I don’t agree with, I don’t even like, but those researchers should… that the NIH should the opportunity to publish those papers. I want to lead by example, but I also want to encourage, and this is something I think the Trump administration has caused a lot of angst in the scientific community, in the scientific community, the academic community at large, but I think it ultimately, in the long run, is a good thing. The sort of, like, pushing universities to… to adopt policies consonant with this idea of scientific freedom, of academic freedom. Essentially, as a way to say, look, if you don’t do this, then you’re not really a great research partner with us. Right? If you don’t have these policies that allow the scientists at your institutions to have their ideas and not suppress them, to allow free speech at universities. Really, the universities that don’t have those kinds of free speech environments are not good environments to do science. You’re always looking over your shoulder, wondering if the paper you’re writing is going to get you canceled. Well, you’re not going to write that paper. Right? And you cannot have this sort of, like, sort of political apparatchic overseeing hiring decisions, and it’s caused a lot of angst, I know, among researchers, that, well, look. My field is fine, how come you’re blaming me for problems in these other fields? But the university as a whole needs to have a culture. that advances that has free speech at its core. Because if you don’t, then you can’t actually trust that the scientific work out of those universities is really Right? It’s only in that free speech culture that you get excellent science.

Jon Hartley: Absolutely. No, I couldn’t agree with you more, and it’s, it’s very interesting, to think about, yeah, I mean. cultural universities right now, and, and how it’s, how, how it’s, shifting, or, or, or maybe not shifting, but, you know, certainly, you know, President Trump’s done a lot to, to change, some of that,

Jay Bhattacharya: His very first… one of his very first executive orders was to reestablish free speech in this country. I was part of a lawsuit against the Biden administration, because the Biden administration, they had a systematic policy, Jon, to suppress free speech, right? They would go to social media companies, order them, essentially, to take down vast pages of even true scientific ideas, like, you know.

Jon Hartley: That’s good.

Jay Bhattacharya: if you’re vaccine injured, they went to Facebook and told people to… told Facebook to take down… Private pages where vaccine-injured people will just talk to each other.

Jon Hartley: Right?

Jay Bhattacharya: They ordered Twitter, a whole… I mean, you could… this lawsuit, this Missouri v. Biden lawsuit, uncovered vast evidence of a all-of-government approach to suppress speech contrary… on scientific matters, contrary to what the Biden administration thought was good, or true, or just. And they were often wrong. They… they pressured… social media companies to suppress… I was… I was actually blacklisted at Twitter the day I joined, in 2021. Wow. And, you know, the Supreme Court ultimately ruled that I and my colleagues didn’t have standing to sue, because we didn’t have an email that said, from Biden’s folks to the Facebook or something, that said, censor Jay. What we did have is emails that said, censor the kinds of ideas that I was espousing.

Jon Hartley: I did that.

Jay Bhattacharya: masking toddlers was a bad idea, that opening schools is a good idea, that, you know, that vaccine mandates made no sense, given that the vaccine didn’t stop the spread of COVID. They suppressed ideas at scale. And the Supreme Court said, that’s fine, the government can do that, as long as they don’t name a single individual.

Jon Hartley: Yeah.

Jay Bhattacharya: Right now, the main thing protecting free speech in this country is President Trump’s executive order saying that the government’s not going to do that. I’ve been watching, like, this brouhaha over some late-night comedian, what’s his name?

Jon Hartley: Jimmy Kimmel.

Jay Bhattacharya: Jimmy Kimmel, right? .

Jon Hartley: Over Charlie Kirk.

Jay Bhattacharya: Yeah, what you had there is, like, you could see it, like, the guy was, like, he was gone for 3 or 4 days because he’s… he essentially made, you’re right, he made some, some, basically a false statement about what Charlie Kirk actually believes in the, in the wake of his death. And a lot of people got upset, and they were, like, writing to their local TV station, saying, why are you having this guy lying about Charlie Kirk, the guy who’s, like, you know, who’s just been assassinated for his political beliefs and free speech beliefs? And he’s pulled off the air for, like, 4 days by ABC, And somehow that’s a free speech issue. it’s not the government telling ABC to pull them off the air that did that, it was the… it was the… it was the individual… people writing their local TV stations. You can see this, because after he was restored, you know, dozens and dozens of the local channels are not gonna show him again. Right?

Jon Hartley: That’s consistent with Greece.

Jay Bhattacharya: speech. Like, that’s… that’s speech based on, based on, like, what… what people are willing to… interested to hear. Like, I… I don’t have a right when I put a tweet up on Twitter to have millions of people look at it. But I do have a right to put now, a right to put whatever I want up on Twitter.

Jon Hartley: Plumbing.

Jay Bhattacharya: You shouldn’t have the government essentially tell people… and, you know, if you think about the difference between Jimmy Kimmel and what happened during the pandemic and the Biden administration. Let’s say the worst case, let’s say you believe, and you’re listening to this, you say, oh, well, look, the government did say to ABC, take Kimmel off. Well, didn’t, but, like, let’s say you believe that. At least there, ABC can say, well, Kimmel, you’re being taken off, the government’s telling you to take us off. But what the government did during the Biden administration was say, take all these ideas off, and I wouldn’t even know. They could do it anonymously. Its vast power to suppress speech is what the Biden administration did, and got away with it, frankly. And as a result, millions of people are worse off. the kids didn’t get years of schooling that they should have had. They lost their jobs over vaccine mandates, they couldn’t visit their loved ones in hospital as they were dying. All this because the honest scientific debate that should have happened during the pandemic did not happen, thanks to these speech restrictions. We can’t have… we can’t have that for lots of reasons, but certainly we can’t have scientific progress unless we establish an environment where speech is absolutely free in the sense that I mean… that I’ve been talking about it.

Jon Hartley: Absolutely. I have one last question for you, Jay, and it’s, it’s about animal testing. So, animal testing, my understanding, has actually, lessened, or I know, you know, there’s this terrible, you know, instances of animal testing on beagles that was going on, I think, under… the NIH purview. Some of this has stopped, and… my sense is that you have a position that, you know, we should avoid animal testing, whenever, you know, wherever possible, unless there’s, no alternative sort of viable model. I mean, tell us a little bit about that in terms of what’s going on. I think there’s some people out there that would be very, interested and excited to hear, that, That, animal testing’s been, reduced under, under your tenure.

Jay Bhattacharya: Yeah, I mean, it’s actually interesting, like, PETA, you know, the People for the Ethical Treatment of Animals had sent me flowers when I put this, the policy I’m about to tell you in place. Although there’s some groups that still don’t like me, because they want zero animal use. So, first, let me just set the stage. So, animal use and research… for… is… has been a mainstay for biomedical research for many, many, many… for essentially centuries. And you can understand why. Like, imagine you’re trying a new drug out for the very first time. you can’t give it to humans to start. You just cannot, because if you do, you don’t know the dose, you don’t know what if it’s lethal, you have… you need to have some sense of, is it… is it… is it… You know, what the safety is. before you give it to a first human. you have to know a lot about the new drug or molecule before you give it to a human, right? And then there’s, like, animal systems that indicate something about the human physiology, right? So, like, the first A knowledge of how our circulatory system came from animals, and analysis of animals. You know, William Harvey. And so, like. you can understand why animal use is part of biomedical research. At the same time, there’s a lot of animal use… animal models are just thoughtlessly used, thoughtlessly in a very, very simple sense, a single sense, meaning the question is just people are used to using some animal model. And they don’t ask whether the thing you learn from the animal model can be translated over to human… to something that’s useful for humans. And in fact, occasionally, you’ll have animal models that mislead you. Right? So, like, you know, you have a rat model, or mouse model of Alzheimer’s disease. You can cure the Alzheimer’s disease in the mouse, but that… Treatment that works in the mouse does not translate over to humans. Well, then why are you even working with that model if the knowledge you gain from that mouse model doesn’t translate over to humans? So that’s the new policy I put in place. There’s a woman who’d been working at this in the NIH for more than a decade, named Nicole Kleinstreuer, who sort of… who taught me about this. there are now huge advances, in, alternatives to animal models. For, in many cases, you can use these things called organoids, which are, like, essentially tissue cells on a chip. You can have, in silico, meaning, like, AI methods, a whole host of other methods that sometimes replace the animal models that people traditionally use, and do better at predicting what will happen in humans when you give a new drug to it or something. Right? And so that… that’s the new policy. The new policy… first, you can’t have unethical treatment of animals. You can’t have beagles that are tortured. That’s… that’s just a given. That’s never gonna happen. And if it does happen, we’re gonna go… we’re gonna put the hammer down on you. And if you do use animals for research, you have to justify it by saying… by showing that the research that you’re doing, the knowledge you’re gaining, can translate over to human activities, human applications, and also that there aren’t other alternative methods that could do it better than the animal model itself. It’s… the goal is the mission, which is advance human health through research. advanced longevity through research. That’s the goal of that, of that. And a happy byproduct of that is that we’re not doing research on using animal models that aren’t necessary for advancing human health.

Jon Hartley: Well, that’s fantastic, and I’m sure there’s many beagles, animals, and people who thank you for it. Jay, I really want to thank you for coming on, this has been an amazing conversation, really enjoyed it, and it’s so great to see you, and hear how you’re doing at NIH, and to hear about your new vision for it, so it’s a real honor to have you on.

Jay Bhattacharya: Thank you, Jon. I’m looking forward to coming back and visiting Stanford someday when I finally get, you know, out of here.

Jon Hartley: We’ll look forward to having you.

Jay Bhattacharya: Alright.

Jon Hartley: This is the Capitalism and Freedom of the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, public policy. I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Art Laffer, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast with the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I’m Jon Hartley, your host today. My guest is Arthur Laffer, a legendary economist who is the famous namesake and popularizer of the Laffer Curve, which depicts the relationship between tax rates and tax revenue. On top of Art’s career in academia, he’s also an investor, having founded Laffer Investments and has advised countless politicians from Richard Nixon working in the Nixon administration, to Ronald Reagan working in the Reagan administration, working on Reagan’s Economic Policy Advisory Board, and most recently working with President Trump, who awarded Art the Presidential Medal of freedom in 2019.
Welcome, Art.

Arthur Laffer: Thank you very much. Jon, it’s so nice to see you again.

Jon Hartley: So great to see you as always. And I really am excited here to talk to you because I know you well and, and I really want to, I think, shine a light on, on your early life and, and all your incredible accomplishments.

You know, you, I’m curious, you know, how did you first get interested in economics and how did you make your way to Yale and then to Stanford to do your PhD in economics and study under the famous international economist Ron McKinnon? I’ve actually, I’ve seen your PhD dissertation here. We have a room with all the PhD dissertations of past Stanford students, and I’ve seen yours in this room of many red books with all the dissertations. I’m curious, what was it like when you were here and how did you actually get interested in economics in the first place?

Arthur Laffer: Well, it was really cool. I got interested in economics. I went to the University of Munich. I took a year off from Yale, by the way. I got into Yale by privilege. My dad went there, both my brothers went there. We are a Yale family. So it was natural, just sort of inherited thing there.

And I took a year off at the University of Munich, where I had been a math major at Yale. And I got to Munich and they didn’t have any math courses I hadn’t had. So I decided to try which is macro and microeconomic. I fell in love with it, came back to Yale, changed my major, was an economist there, majored in it, cleaned up, hit the ceiling, then went to Stanford Business School.

You know, family’s business. My dad was head of a large company in America for many years. Privileged family, all that. And I fell in love with economics. I took all these courses. I took my core exams in the econ department when I was in the business school. I was the only student to do that out of something like 200 students.
And I aced them. So I switched over and I got my Ph.D. in economics after my MBA and, and then I went to the University of Chicago where I took my first year as a year’s leave of absence to go to Brookings Institution with Emile Despres, who was a professor at Stanford. And well, you know, it’s all written in the stone from there on my career, but it’s. I love Stanford, I love the business school and I love switching into the econ department. And Ron McKinnon was spectacular, as was Emile Despres, by the way. You know, we had a big good group of international economists back then, and that’s my specialty, pure trade and international money. And they were really terrific. And I got my first publication in the AER before I entered graduate school in the economics department. How’s that?

Jon Hartley: That’s amazing.

Arthur Laffer: In fact, my first publication was in Reagan’s first economic report of the governor in 1967. That’s my first citation. So how’s that for cool?

Jon Hartley: That’s amazing. Okay, so I guess a few questions. So like, Ron McKinnon, for those who don’t know. Ron McKinnon, you know, famous international economist, spent most of his career at Stanford. You know, I think, you know, maybe like a 50 plus year career. And he was famous for coining financial repression, focused on China a bit later.

I mean, I’m curious what, what it was like at that time. I, I mean, I, my sense is like, you know, Stanford’s I always think of as. It’s the sort of department that Ken Arrow and others built or it’s kind of the environment that Ken Arrow and others built.
But I’m curious, what was it like, you know, at the business school at the time? What was it like doing the MBA and segueing into PhD? Strangely, I also sort of have an MBA, and finishing a PhD and all that as well. But I’m curious, what was that like in California at the time? I mean, Governor Reagan in California, what was California like?

Arthur Laffer: Well, he wasn’t quite there yet. I mean, remember I came in 63 and Reagan didn’t take office until 67. So the first part was still under Edmond G. Pat Brown there. And it was a very exciting, very.

I don’t know what it’s like today in the courses, Jon. I don’t. But at that time, Stanford was extraordinarily rigorous mathematics. Ron McKinnon was no BS, period. He, he had me do proofs and theorems there I was worked for Moses Abramovitz. I was the proofreader for why Growth Rates Differ by Ed Denison. So this is the detailed numerical stuff and detailed mathematical stuff. So we worked in statistics and math very, very heavily at that time. And I, I think it softened a great deal to be honest with you, at Stanford. But we came out of there, we were,

Jon Hartley: they let me in. Clearly that, you know.

Arthur Laffer: Well, you know, it’s, it’s not who they let in, it’s who they let out that’s important. And I am sure you’re going to be let out a better man and a better economist as. But that time you really had to be rigorous and McKinnon was as rigorous as anyone was.

Emile Despres was the love of the century. I mean I just love that man more than anything. Ken Arrow was, was an important part of the department but he was separate. He was in Whatchamacallit House, Sarah House, which was where Ken Arrow and the mathematical commons. We were all in Encina Hall there, the whole group of us, which you probably don’t even have anymore.

The business school wasn’t built. We were all at history corner, but it was two very different things. And I had very little interaction with Ken Arrow. A lot of interaction with McKinnon, with Emile Despres, with Paul David, Paul Holmberg. A good group of solid economists there. I just loved it.
Just loved it.

Jon Hartley: That’s fantastic. And my understanding is I think some of the mathematical economics Ken Arrow sort of grew out separately. I mean we have the MS&E department as well, which is all separate. So there’s all these different, different groups of economic scholars or economics related scholars here and between certainly in these times we’ve got Hoover and we’ve got the Stanford Economics department. There’s SIEPR, we’ve got the business school. There’s also the political science departments, FSI, which is just foreign policy, and all these folks are doing economics to some degree. I’m curious. I guess HP has always I think been one of those big, I think founding sort of companies, if you will, in the area.
I mean, was the tech sort of, was this at the time or not?

Arthur Laffer: My job when I was at Stanford, I was, you know, very young. Obviously, I came and I was married. Most people were not. I had a baby, so I had a family and so I worked at night. I was night watchman in Shockley Transistor and 1800 Page Mill Road which was the opening one that was before the group left and formed their new company there. Before all the deserters left Shockley. So I was night watchman there. So yeah, we were really big on that. In fact, Shockley asked me to be his research assistant in the university. And I told him I really didn’t have time to do that. I could as night watchman, I could do all my homework there, four hours every night. And he wanted me to come in and actually be a real serious research assistant and do this genetics research. Thank God, I didn’t do that. Just what I need is another scar on my back for whatever conservative stuff these guys do.

Jon Hartley: Great. Well, okay, so did you know anyone in the early, like any of the early Reagan people who are in California and advising him at that time? Do you cross paths with any of them?

Arthur Laffer: Later on, I did, very much so. You know, my godfather was Justin Dart, who was Reagan’s best friend. And so my relationship with Reagan was strictly familial, was privileged, was all of that. When you’re someone’s best friend, you get to intersect in the circles. And so when I came back to California in 76, I was immediately in the social set with Reagan. When Bob Hope died, for example, I was the escort for Dolores Hope and all of us in the Beverly Hills, Bel Air, that era, Palos Verdes, Rolling Hills, that was mine as I was the kid and all of that. So that’s how I really got to be superly close with Reagan and all the people around Reagan. But I knew them all really, really well and doing a lot now with it.

Jon Hartley: Terrific, terrific. Okay, so California, your first job coming out of Stanford was at UChicago, University Chicago.

Arthur Laffer: First, yeah. Job, yes. But I took a leave of absence my first year out and I went to Brookings. At Brookings, And then I came back to Chicago where I’d never been before.

Jon Hartley: And I know you later taught it at USC and Pepperdine as well. I’m curious what was like the UChicago this would have been I guess in the late 60s, early.

Arthur Laffer: 60s, 70s that era, I came back for one year, my second year on the faculty, my first year in location. I was pretty lucky I got a lot of published articles in the top journals everywhere at AER, all of these things there. And so I think I got the fastest promotion to tenure at Chicago in their history in econ.

Promoted to tenure and then George Schultz in 1970 asked me to go to the White House with him as his right hand person. So I was the top staff economist in the White House from 1970 to 1972. In the first year of the Office of Management and Budget.

It had been the Budget Bureau before. But when Schultz came over and took it over, he changed it to the Office of Management and Budget. And I was his choice. My first thing before I even got my office was to go to China with him and John Ehrlichman and made the first trip to China. So I was the first American in modern times at least to go to China in October of 1970. And it was just all cool stuff. I mean, just amazing, I had no idea how cool it was until later.

Jon Hartley: It’s amazing. And you know, I think a lot of people don’t necessarily appreciate, you know, Schultz as, you know, Treasury Secretary.
I think he’s tied with, I think, the most number of counter appointments. And-

Arthur Laffer: yes, he was

Jon Hartley: -obviously a big, you know, a huge influence here at Hoover. But, you know, I think that some of the things that I think people don’t really appreciate, you know, about that time and what was going on was on, on the sort of the treasury side of things was, you know, I think, you know, the creation of what was, you know, the predecessor to the G7.

You know, we have all these G7 meetings today. I think that was very much created out of the Schultz treasury at that time.

Arthur Laffer: Well, that was before Schultz treasury that I’m talking, here he was head of the Office of Management, but his first job was Secretary of Labor.
And then when he moved over to be head of the Office of Management and Budget, this newly created agency is when I joined him in nineteen seventy. Now at that time was just before the Camp David wage and price controls, devaluation, the dollar, the 10 import tax surcharge.

All the stuff you and I hate and despise and disagree with to the limit. But Nixon, I enjoyed Nixon personally very, very much. But this was George Schultz’s first thing there. And then of course, what he did was he left that. He went become Secretary of the Treasury.

And I went with him for that. I was his consultant two days a week from the University of Chicago. I went in there and I had my own little office right next to his, right across the little hall there. And it was just a cool, cool time. That’s when we went off gold, when we devalued the dollar.

We did all the Smithsonian Accord. All of that stuff occurred in that period. And it was a very exciting period. A very, in my way, bad period in sense of economics. I mean, you know, it’s when government finally monopolized money as you know, Jon, before 1913, money was private. There was no government money. Now, the government did do three things. It defined what a dollar bill, a dollar was. It’s 1/20 of an ounce of gold, it’s 1 ounce of silver. You know, that’s what they defined that. Then the government also, prior to 1913, did have a mint that minted coins.

If you brought in bullion, it minted coins correctly and charged a fee for it. So did a lot of other places mint coins. And the third thing the government did which was really important was that it audited banks’ balance sheets. So if you said your balance sheet and your income statement was such, they went in and audited it and made sure it was true.

And what was before 1913 there was no currency as we know it. There was banknotes which were issued by individual banks. Some sold a slight discount or premium to another bank or so, but that was the money back then. And obviously from 1790 until 1912, let’s say the US had bibbles and bobbles and inflation, but there was no generalized inflation for 130 years there. And then, of course, once we started the Fed, which was in 1913, the government started to monopolize money. Then Roosevelt devalued the dollar from $20.67 an ounce to $35 an ounce, ba, ba, ba, ba. Interest equalization tax, voluntary, ending up in the Smithsonian. In the next 120 years or so, we’ve had huge inflation, I think the price levels increased 33 fold.

It’s just another example how government shouldn’t be in the business of doing what the private sector does better. There should be no government money. There should only be private money today. And it should not be, it should not be run by Powell. I mean, what, I mean, this guy’s not competent. Government shouldn’t run money, it should be private.

Jon Hartley: So I will get into my-

Arthur Laffer: I got you to a different field, didn’t I, quickly?

Jon Hartley: I know. So I guess this is my, my question for you. So, you’re working at UChicago. You’re working at OMB. You know, you’re working with Schultz, you know, going back and forth between Washington, you were there, Chicago in the late sixties.

And around that time, you’re hired as an international economist.

Arthur Laffer: Yep.

Jon Hartley: And I’m sure at that time you, you, my, my guess is you’re probably in the same seminars as Harry Johnson. You know, the famous

Arthur Laffer: Bob Mundell was the best, was the leading international economist of the world.

Back then. I worked with Mundell, it’s the Mundell-Laffer hypothesis. All the stuff we worked together. He was my primary thing, very big fan of Ron McKinnon’s, both of them Canadian, both of them the same economics. He loved my training with Emile Despres and Ron McKinnon, and we did tons and tons of work together.
He took-

Jon Hartley: All three of them were Canadian? Robert Mundell was Canadian, Harry Johnson was Canadian, Ron McKinnon was Canadian.

Arthur Laffer: Yeah.

Jon Hartley: And some people would argue that, I mean, part. Part of what, you know, inspired the Mundell-Fleming hypothesis or conjecture, you know, and trilemma was you, the fact that Canada was actually the first sort of break off from the Bretton Woods fixed exchange rate system in the 50s and to float briefly before they, they went back—

Arthur Laffer: Almost got killed.

Jon Hartley: --And that sort of influenced Mundell to start thinking about, you know, should we have a fixed exchange regimen? Floating exchange rate regime. Mundell and Milton Friedman had obviously this you know, very big debate in, in that time.

Arthur Laffer: Well, we were all, we were all fixed exchange rates.
We were gold, gold standard people. Mandel and I and Paul Volker in there and Milton Friedman was floating rates. And you know, just for the record, floating rates don’t work. They don’t work.

Jon Hartley: It’s a debate that still goes on to, to this day.

Arthur Laffer: Yeah, but it shouldn’t.

Jon Hartley: Yeah, well, I mean, you know the, the, you know, the end I guess of Bretton Woods and, and the breakdown of the fixed exchange rate system. You know, it’s ushered in.

Arthur Laffer: This fixed exchange rate system didn’t break down. The fixed exchange rate system was demolished by sabotage.

Jon Hartley: Yeah,

Arthur Laffer: we had no problem with a fixed rate system for three, four centuries before 1913. It did really well and the monopoly of government and then floating rates did really badly post 1913, and it ended up squirrely as all get out. We almost went back to fixed rates with Reagan. We came very close.

Jon Hartley: Well, there was the gold commission in a Schultz kind of lad and there was a bit of a revisiting of some of these things.

Arthur Laffer: A total revisiting. And Reagan was a hard money person as was Paul Volcker. Paul Volcker was gold standard all the way.

Jon Hartley: He, I mean Volcker wanted zero to his, you know, for his entire life wanted a 0% inflation target.

Arthur Laffer: Me too. Me too. Mundell too.

Jon Hartley: I guess there was why 2% over long periods of time. It’s a lot of inflation. But you should have 0% said was the argument, I mean, was it Friedman who was pushing back for flexible exchange rates and who won over Reagan in that?

Arthur Laffer: It was 100% Friedman through George Schultz that got the Camp David to go to floating, go, you know, devalue the dollar, go off gold and to have the Smithsonian Accord where you had a floating rate 100%. Milton Friedman. Now there were a lot of other economists who agreed with him, but he was the push.

He was the one with George, who convinced George to get in there and, and, and get the President to go along with it. And you know, I was, I differed with him on that very much so to express it. But George was the most wonderful person in the world.
You know, he could, you could disagree with George or whatever without being disagreeable. And as his staffer, the only thing I always wanted was that he listened to me, not that he agreed with me. I was never elected to make decisions. I’m only there as an advisor, the same way I am with Trump, the same way I was with Reagan, by the way.

I’m only there as an advisor. You make the decision, but as long as you listen, I’m fine with you. And that was the same thing was true with, with Nixon. I disagreed with almost everything Nixon did. Devaluation, going off cold, tax increases, you name it, wage and price controls. I mean, but there wasn’t a thing Nixon did that, that I did. But I like Nixon very much. Personally. I love George Schultz.

Jon Hartley: Yeah, I mean, Nixon arguably, I think one of the smartest presidents that, that we’ve had, you know, the, all sort of policies and, and other activities aside.
But, you know, I, I guess the Friedman argument for flexible exchange rates was, if you have PPP, if you’re fixing exchange rates, then it kind of allows prices to jump out of whack. And, and I guess this. Anyway,

Arthur Laffer: so that’s all. How do they get out of whack between Chicago and Cleveland?

That’s a fixed rate system, isn’t it? Now, how about between California and New York? Or they out of whack? California should devalue. Come on.

Jon Hartley: This is the Mundell argument, the optimal currency area.

Arthur Laffer: Well, you know, the optimal currency area was the one about Canada, the West versus the East.

What Mundell really pushed for very much was a currency area and a common currency area, which he put to Europe. That wasn’t an optimal currency area in Europe. It was the euro that he thought should be the total currency. And that then that should be juxtaposed against the dollar, maybe against the yen, whatever.
But Mundell was very much the fixed exchange rates. If you see his article. Mine was two arguments for fixed exchange rates. And his was the case for fixed exchange rates. We did all that stuff. Mandel was very much in that line.

Jon Hartley: Right. Influenced the creation of the euro. I mean that, you know.

Arthur Laffer: Well, that is what. Getting rid of floating rates.

Jon Hartley: Exactly.

Arthur Laffer: Thank God. And he was right. He’s been right on all of these things. And we’re still pushing to get, get back to a sound monetary standard. And that’s why the euro, that’s why Bitcoin is doing so well.

That’s why gold is so high priced. Everyone wants to get out of government money. So they just are crap things and they want a private money system back again, one money system for the world.

Jon Hartley: So, I guess the question, how did you become a tax accountant of all this?
You know, you’re international coming out of, out of graduate school, you know, obviously your money and, and all these things front and center in the late 1960s and you know, hanging out with Mundell and have been colleagues with Mondell and all these other, you know, Friedman and so forth.
You know, how did was tax policy always.

Arthur Laffer: It’s like getting a virus, it’s like getting the bacteria in your system comes and eats you alive. You know. I was the chief economist at the OMB when it was formed in the White House. So there I, as far as credentialed economists, I was the ranked number one there in the White House.

The Council of Economic Advisors was over in the old Executive Office Building and it was. And you’re immediately involved in all policy matters. And I developed a little model that are called the formal model of the economy which was published in the Journal of Business in 1972 I think it was.

And there I did a test of the monetarist model, the Keynesian model and the efficient markets model. Back then we didn’t have supply side and I got into some real deep trouble. Government spending using a seasonally unadjusted co adjusted. You can go back and look at the article there.

It created huge, huge kerfuffle in the world. If you go back and look at the article there, I found that government purchases of goods and services increased GDP by the amount of the increase in purchases of goods and services in the first quarter and then for the next three quarters went back down to where it otherwise would have been.
So it was 100% crowding out of shifting government for there. And I couldn’t understand that. And government transfer payments actually reduce GDP growth. So

I was struggling with this, being trained as a macroeconomist back then. I, I was struggled with this terribly and, and finally came to the conclusion it’s incentives and supply.

If you tax people who work and you pay people who don’t work. Do I need to say the next sentence to you, Jon? No. That was supply side economics. Government spending reduces output, not increases it. Taxes are a disincentive to work output and employment transfer payments pay people not to work, they tax people who do work.
And that was the evolution of supply side economics, which is the exact opposite of Keynesian or monetarism. I am not a monetarist at all. I’m not a Keynesian. I personally believe that people don’t work because of their jobs. I believe that people work to get paid and they get work to get paid after tax.

I don’t believe that people save their money because of income, incomes being higher. I believe they’re save their money to make an after tax rate of return on their investments. Hello. It’s an incentives-based model. I believe that if you have two locations, A and B. If you raise taxes in B and you lower taxes in A, producers and manufacturers are going to move from B to A. You know, people can change the location of their income, the timing of their income, the volume of their income and the composition of their income, all based on taxation. And that’s came out of my paper in 1972. And I was at sixes and nines. I was completely at odds with my own concept until all of a sudden this classical model started rolling in on me and bang. And then you can see all the rest from that. Mundell was right there with me the whole time. It was just a great, great fun. And that’s why now I spend so much time on macro. It’s just. It’s just incentive economics, Jon. That’s all it is. I mean, nothing more, nothing less. Just like international economics.

Jon Hartley: Absolutely. You know, and it’s fascinating. I think there’s now, you know, we’re 50, roughly 50 years later. You know, I think there’s, you know, whole renaissance going on in, in fiscal research and, you know, a lot of work done by Valerie Ramey here and work done by John Taylor as well.
You know, just showing that fiscal multipliers are much smaller than people. I think originally

Arthur Laffer: they don’t exist. They’re negative. They’re negative, Jon. They’re negative. Negative. You know, have you ever heard of an. Of a person spending himself into wealth? It’s stupid. Have you ever heard of an economy taxed into prosperity? It makes no sense. Now, there are certain functions the government does that it does better, like military and stuff like that. We’re not talking about that. We’re talking about transfer payments. We’re talking about that. And let me, can I go through with. One second with you on the transfer theorem, because this is, this is so important, Jon.

You know, the transfer theorem is that all transfers are where you take income from one group and give it to another group. That’s a transfer. We usually think of it in terms of from those who have a little bit more to those who have a little bit less.
You with me? Now, if you take from those who have a little bit more and give to those who have a little bit less. By taking from those who have a little bit more, you reduce their incentives to produce, and they will produce a little bit less. By giving to those who have a little bit less, you. You provide them with an alternative source of income other than working, and they too will produce a little bit less. The theorem here, and it’s a theorem it’s not my opinion. It’s not. I’m tall, I’m short, I’m Harvard, I’m. It’s math. Whenever you redistribute income, you always reduce total income. And that’s the whole basis of stimulus spending is redistribution of income. And it doesn’t work. It always reduces income.

Jon Hartley: I mean, my sense is that having looked at a lot of say, myself as well, and this is the arguments that, you, John Taylor and Valerie Ramey there’s made is that really the challenge with transfers is that they largely get saved and they don’t get spent. So you know, this idea that like.

Arthur Laffer: People, that’s, that’s wrong. Let me just say the problem with transfers is they have to be taken from someone else.

Jon Hartley: Well, that’s true too. I mean.

Arthur Laffer: No, no, no, that’s not true. That’s not true too. That is all that’s true.
You know, by taking from people who have, you reduce their spending because they now have less than they otherwise would have had, that will de-stimulate the economy in the same way. The people who receive the money will spend more, the recipients of transfer payments will spend more. That’s true.

But the payers of transferred payments will spend less. The income effects. Get your Slutsky equation out. This is where training today is so bad. Get your damn Slutsky equation out. In a, in an economic system, these income effects always, for a transfer or a tax rate change, always. Sum to zero, always. But the substitution effects don’t. I had this problem with Senator Nelson in 1974 when he, when we were talking about the 600 buck tax rebate from Jerry Ford by the, that guy. And you know, I was trying to explain the substitution effects to the Senator, and I couldn’t find it. He said, you know, and I was on the, is testifying with Gardner Ackley, Paul McCracken and Otto Eckstein, okay? They were the three senior grown up economists who really wanted to do this transfer. And finally I said to, to the Senator, I said, sir, if those three economists are correct, that $600 stimulus will increase output, employment, production, what the hell’s the matter with you?

Why only $600? Why not $6000-60000-60000-600000. Why not 100% of GDP? So everyone who produces and works receives nothing. And all those who don’t work and don’t produce, receive everything. What do you think would happen to GDP? And he goes, God--

Jon Hartley: probably not much.

Arthur Laffer: --it would go to zero. And that’s right. And these guys just don’t get, they don’t understand straight up, a transfer system ala Keynesian is you take from someone and their spending goes down. You give to someone else, their spending goes up. That’s true, that’s a zero-sum game. But the substitution effects make it a huge negative sum game. And that’s what is. And that’s why the transfer theorem is so true. Every time you transfer resources, you reduce total production. Period. Sorry, Jon.

Jon Hartley: No, I’m, I’m, I’m with you. I mean on incentives, the facts.

Arthur Laffer: Get that Cogan guy and get him on here TV with me get them all on here. Let’s go to, let’s have a good me out there to Hoover and do a debate. And redistribution is the same silly thing. These guys at MIT, Saez and Piketty and Stantcheva and all those, whatever, you know, everyone knows that the only way of having equality and income is when everyone’s zero. That’s, that’s the transfer theorem in the limit function. And everyone knows the data show that every time we’ve raised the highest tax rate on income earners. Every single time, Jon, the economy’s underperformed, tax revenues from the rich have gone down and the poor have been hammered. Every time we’ve cut tax rates on the rich, the opposite, the economy has outperformed. Tax revenues from the rich go up and the poor have been provided employment and good income earning opportunities.

Jon Hartley: I don’t think you get much disagreement from folks at Hoover. And as you point out, John Cogan has an excellent book, the High Cost of Good Intentions, which is excellent.

Arthur Laffer: Why don’t you look at taxations? Taxes have consequences. I looked at every single tax return in the US we have the data. If this is not an opinion piece, I could give a damn what your opinion or anyone else’s opinion is. And you should give a damn about mine. This is about facts, not how you feel. And the facts are whenever we raise tax rates on the rich, the economy underperformed. Whenever we lowered them, it outperformed. Revenues exact same, and the poor. Bingo. What more do you want?

Jon Hartley: So I, I just want to get a little bit into just the history of how the Laffer curve became famous. I think this is a long story, you know.

Arthur Laffer: Became obnoxious and then famous for being obnoxious first.

Jon Hartley: Well, a lunch in 1974, Ed Atkin, Dick Cheney, Don Rumsfeld, then chiefs of staff to President Ford, Jude Wanniski, legendary Wall Street Journal journalist. I’m curious. I want to hear sort of the, I guess, the backstory, how you tell the story.
I mean, how long were you thinking about, you know, sort of the the Laffer curve, thinking about drawing the the relationship between tax revenue and tax rates? Were you planning on, was the pitch plan, was a planned thing, or was it unexpected that you were going to draw this?

Arthur Laffer: Let me tell I’ve been teaching my classes on the Cobb Douglas production function, called the CLO model, which I developed long before I told you how I was frustrated. And then I did the model where I had six factors, six unknowns, and solve the systems there and showed all the different things there.
And one of the things was that if you raise tax rates on a factor of production, the returns there, you reduce that factor’s employment, you reduce other factors employment because they’re withdrawing the complementarities out. And sometimes revenues go up and sometimes they don’t. You can overtax a factor, you can undertax it.

It’s like any product in the marketplace, if you tax something too much, you’re going to get less tax from that and tax too little less and having dinner with them and they just done the whip inflation now, which was a 5% tax surcharge. Jerry Ford’s brilliant, incredibly insightful idea, just stupid as it comes.

And I was telling my classmate, Dick Cheney was my Yale classmate and Don Rumsfeld were one of my best friends. I said, you know, you guys, you may get 4% more revenue, you gave me 3% more revenue, but you won’t get 5% more revenue. And in fact you may lose revenues, and then I went through and just did what I did for my class, which showed that you’re over tax, you’re gonna get less revenues, you under tax, you, you’ll get less revenues, but you’ll still get positive.

And they saw the light, I guess. And that’s when was there and wrote taxes revenues in the Laffer curve. And it’s all legend from there on.

Jon Hartley: It’s amazing. So there’s, I’m just curious, you know, just on the Laffer curve there’s I think many debates. Nobody debates that the Laffer curve has some inverted U shape that, you know, it’s, you know, a 0% tax rate, 100% tax rate, there should be zero revenue.

Nobody debates that. I think the debate comes in as what’s the shape of the Laffer curve. And I think there’s debates about at what tax rate the revenue maximizing product curve was at.

Arthur Laffer: Let me, let me disagree with you first. When this was done at that time, the historical Laffer curve, which was everywhere, the Laffer curve goes back a thousand years to the Mukadimah and Ibn Khaldun.

It, all the classical economists had clearly understood it. Price theory understood it completely. The Laffer curve, I didn’t invent it and I didn’t name it. But at that time in macro that was not the case. They did the type of Congressional Budget Office and analysis that if you raise tax rates by 10%, revenues will go up by 10%.

It was all static analysis, no dynamic. And that’s what I brought into the discussion there at that time. That was very big difference. John Was that at that time it was literally that if you raise tax rates, even at 110% tax rates, you still collected more revenue. There was no incentive effect of taxes on the supply of goods and services.

Our common friend, Ed Shaw put it this way. He said in the demand side models of monetarism and Keynesianism, supply is a rubber womb which accommodates unembarrassingly any fetus of aggregate demand. And this is where I got a lot of the supply side things were from Ed Shaw there at Stanford and Emile Despres.

But now the debate is where is the proper point on the Laffer curve? That is correct. Everyone has completely conceded the Laffer curve. I mean, it’s obvious. It’s the everyone all conceded before I was born too, by the way, just for the record. Now the issue is there and what you’re finding out is the more and more you look at it and the more and more people understand that it’s not just output, it’s tax sheltering.
It’s changing the location of your production, changing the timing of your production, changing the composition of your production, changing the volume of production, changing how much you report tax sheltering. And all this stuff that the Laffer curves effect on revenues is getting lower and lower and lower and lower and lower and lower.

Property tax rates in the range of 1 to 2% are now counterproductive with regard to revenues. International taxes are counterproductive with the tax base. The larger the tax base, the more likely it is that tax revenues will be increased. The longer you’re willing to wait, the more likely it is that tax revenues will be lost.

All of this stuff comes into now just how really dominant the prohibitive range of the Laffer curve is. I mean, just show -Warren Buffett in his 2010, 2011 letter to the New York Times on his income where he paid seven and a half million dollars, $6.9 million in taxes on an income of 12 and a half billion.

Clearly showed that, you know, he doesn’t pay taxes. I mean, it’s way out there. No one in the top 300 tax fighters pay any taxes at all. They all shelter their income. I mean, clearly the Laffer curve works in all of these areas dramatically and hugely. It works in poor people.

I mean, everyone knows what happens, you know, when people’s incomes go up and they get their, their welfare payments withdrawn. Needs tax, means tax, and incomes tax, it works there, too. I think what’s happening in the debate is everyone’s coming to realize that the prohibitive range The Laffer curve now occurs at very low rates of taxation. 15, 10% of taxation, I mean we were down, we went from 73% in 1921 to 25%. Then tax revenues from the top 1% of income earners tripled, clearly way in the prohibitive range. So what we’re seeing in the debates now is every year it moves. Go look at Simon Bowmaker’s book When the President Calls and Marty Feldstein’s switch in his policy when he did that 86 tax act analysis, he found how all these guys with ease just shifted their income and, and the 86 tax act paid for itself.

Bang, the tax cuts and jobs act paid for itself in the first two years. In the first two years before we even got lags.

Jon Hartley: Well, you know, it’s amazing. I mean one, I think it’s a great point that you make in you know, one like, you know, the Laffer curve is an object that can change over time.

You know, certainly if people find ways to be more mobile with their, their, either their capital or even their labor.

Arthur Laffer: Or even their reporting. Not even with their labor or capital. Take real things aside, just hiring a good shyster lawyer, that’s all it takes.

Jon Hartley: Accountants, lawyers are absolutely part of that.
You’re absolutely right, behavioral response-

Arthur Laffer: Huge part, huge.

Jon Hartley: There’s many-

Arthur Laffer: Hiring politicians.

Jon Hartley: Right, and so it all comes down to this object of ETI, elasticity taxable income, how’s your-

Arthur Laffer: Taxable, it’s elasticity of reported income.

Jon Hartley: Right.

Arthur Laffer: And it’s reported.

Jon Hartley: Exactly.

Arthur Laffer: Tons of unrealized capital gains increases are income. Take Haig-Simon income, it’s clearly income, but it’s not taxed and you have a step up basis at death, duh.

Jon Hartley: So it’s not just incentive facts, it’s many things that go into defining tax payment from elasticity.

Arthur Laffer: Yes, exactly.

Jon Hartley: In the shape of a Laffer curve. And we could also even have, you know, different Laffer curves for corporate income, for individual income, for you know, capital gains type income and, and obviously capital gains.
And I think corporations are a little bit more mobile than individual income, so I don’t really-

Arthur Laffer: Not really, they aren’t. They really aren’t. You’ve got lawyers that can do it anywhere at any time, any place. It’s really amazing.

Jon Hartley: Certainly for high income people that can afford that at least.

Arthur Laffer: Well, they’re the people thatdo it. They’re the ones with tax rates. You know, when you see a group of people hanging out with Obama, Wama don’t think it’s street people. People trying to explain to them what it’s like being poor. These are people from Goldman Sachs who want to put in a new tax deduction there for campaign contributions.

And rich people can buy everything. They have the ways, they have the means, they have the ability to do all that. They can change all these things. And don’t think for a moment they won’t use it instantaneously. It doesn’t take a long time for them to figure this out.

It takes one good meeting with a lawyer and. And then what you do is you hire all the IRS lawyers, which is what Morgenthau complained about. Every time they trained a good tax lawyer, the private sector came in, offered him 10 times as much to come and work on their side against the tax lawyer.

I mean, it’s just nature, and pretty girls attract guys, it doesn’t take a long time.

Jon Hartley: Absolutely. Now, you know,

Arthur Laffer: I hope you’re enjoying.

Jon Hartley: I wanna talk about the Reagan era with you.

Arthur Laffer: Yes, let’s-

Jon Hartley: Let’s talk about just the Reagan era for a minute.
The Reagan tax legacy is a big one. The margin operating cut from, you know, the 70 range to, you know, 20,

Arthur Laffer: 28,

Jon Hartley: 28 when he left office. And I’m curious, like, what. What was the involvement of the Reagan Economic Policy Advisory Board during this time?

thur Laffer: How much?

Jon Hartley: Yourself there?

Arthur Laffer: Myself, it was a lot. You know, I’d done my thing, the complete flat tax, which I’d written, which was a complete. Just flat tax from first dollar to last dollar, no deductions, exemptions, exclusions thing. We, we got the tax cut of 1981 ERTA, which is based upon Kennedy’s tax cuts of 30% across the board, which I was able to get Jack Kemp to do it because his middle name was French and he wanted the JFK the second.
Boy, so we did that one, that one worked. But Reagan phased it in and it caused the 81, 82 depression. But then when we got to the 86 act, which was the real one that was on the paper, I did, which was the complete flat tax, that one, we took the rate down to 28%.

We went from 14 tax brackets to two tax brackets. We cut the corporate rate from 46 to 34%. We did deductions, got rid of deductions, exemptions, exclusion. It was static, revenue neutral. I mean, that was the closest thing to God in heaven that ever existed. And it worked, it worked like mad.

That’s where Marty found that all the people’s responses were tax revenues and the rich went up, went up on that. Go, go ask your, your friend.

Jon Hartley: Yeah,

Arthur Laffer: yeah, sorry, go ahead.

Jon Hartley: No, no, I, I think, you know, I think a lot of people would agree with you that you know, that you know, in, certainly in the, you know, JFK and Reagan tax king era, we, we were on the, the right hand side of the, the Laffer curve and, and

Arthur Laffer: we came down. Yeah.

Jon Hartley: And cutting rates, I think you’d actually get a lot of agreement amongst many economists and so, it’s an amazing time. But the JFK and Reagan revolution, Larry Kudlow and Brian Domitrovic have a great book written on this and-

Arthur Laffer: Yes, they do.

Jon Hartley: And it’s fascinating. I want to talk a little bit. I just want to put away from presidents and federal policy for a little bit because another part of your legacy is on top of working presidents. You’ve had a lot of success in getting states to cut their tax rates. And, and you know, there’s many states ranging from, you know, Kansas, understand Brownback.

There’s, you know, for example, there’s Tennessee where you’re living now. You know, and I, I so you know, there’s a lot of evidence in general, you know, that shows that, you know, states that didn’t cut taxes are now losing people. There’s a lot of great work that’s done by, of folks, Hoover scholars, Josh Rauh and co-author Ryan Shyu showing their behavioral responses to stating of taxation.

And looking at California, how many people have left California in response to further state tax increases in California. And I know you’re one of these people, you know, you lived in Southern California and you now live in Nashville, Tennessee, which is a zero state income tax. So you in fact you yourself are part of this trend.
I’m just curious sort of at a broader picture. I mean, what in your mind is the legacy of tax relief in the states in the past few decades?

Arthur Laffer: Well, started off with Prop 13. I was very involved in that, as you may know, with Howard Jarvis and Paul Gann.
And we cut the highest property tax rate in California from 2.7% effective rate to 1% in one evening a bang. I worked with Jerry Brown closely, if you could see my wall here when he came down. And I spent a lot of time with him and went up there to Sacramento the next day when it passed and worked with him on the subventions and getting it work and started all that we do.

ALEC, American Legislative Exchange Council, does the rich states, poor states, the ALEC Laffer rankings of all the states and I’ve worked on it. Your guys have done a great job as well. And it just super. And yeah, it’s really clear those, those 11 states that adopted an income tax since 1960 have really underperformed the nine states that, that don’t have an income tax have way outperformed the states that have the highest income tax.

It’s it, it. As Larry Gatlin says, it ain’t rocket surgery, it’s just common sense, duh. I mean, why would you go to a high tax location if you can go to a lower tax location? Now I love, love, love California. And if it hadn’t been for Prop 13, California would be West Virginia. Prop 13 is the only thing that keeps you guys alive. But if you look at it coming here, we have no desk tag, no state, all that stuff. I mean, it’s really cool and you know, it’s a great place to be. Earning income with lower tax is a lot more fun.

Jon Hartley: Yeah, well, I just think now in the post Covid era, you know, I feel like in the 2010s this was, you know, sort of like a big debate. And you know, there’s, you know, folks like Paul Krugman who are, you know, attacking you for advising--

Arthur Laffer: He doesn’t do data, but he doesn’t do data. You know, this is, this, see, this is just opinion. Krugman sits there and says, I caused the race riots in Buffalo. Okay, go for it, Paul. You know, he doesn’t do data. And the data are really very clear.

Jon Hartley: Right.

Arthur Laffer: Low tax rate states outperform high tax rate states, period.
There are other things that matter. That’s true, but that is clearly one of the biggest things that matters.

Jon Hartley: And I think you’ve, I think in many respects you’ve won this argument. And perhaps it hasn’t been said. And you know, I just think, you know, it’s really people’s behavior that says it all.

But you know, in the post Covid era, Covid sort of gave this excuse for so many people to move and to switch states. And what’s happened now is, you know, you see these, you know, significant migrations from all these states, you know, Illinois, New York, California to low income tax states.

The Texas is in California. You see tons of businesses moving, tons of corporations moving, tons of people, especially high income individuals who are leaving. And this is borne out in the data point folks,

Arthur Laffer: decades and decades and decades.

Jon Hartley: Right? So I think you won that argument.
I’m just curious, I wanna talk about just economic stimulus for a moment. And sort of speaking of COVID, I mean, you and I actually wrote a few op-eds together in 2020 in national view, Fox Business.

Arthur Laffer: Yes, we did. We had some fun, didn’t we?

Jon Hartley: We did. We did. This was amidst the debate about what to do with COVID and sort of stimulus or really more, I’d say, social insurance. People were not allowed to work. You know, you had these terrible lockdowns. They were being enforced by the government. There’s a question of, you know, what do we do to fill the gap or to help people.

And I think we were on the side of arguing that it should be a thoughtful process in terms of what we do with businesses and employees and how to help those relationships. Endure sort of to offset the negative effects of the lockdown. So we argued for payroll tax cuts and negative payroll tax cuts that would be sort of superior to grants allocated by the Small Business Administration along with unemployment insurance.

Just because it’d be a more efficient way to keep employers in place.

Arthur Laffer: Exactly,

Jon Hartley: rather than working. Through the banking system. SBA isn’t through to do it. I talked to a lot of people. We talked to a lot of people at the time. And, and you know, the problem was, you know, the IRS didn’t have the capacity to do it, to turn the spigot the other way.

That those are the reason that I got. And so, I mean, there’s some weird state capacity issue going on. I’m curious, sort of looking back five years.

Arthur Laffer: It’s just a bad thought process. And this was Mnuchin and Larry Kudlow. I talked with the President on this a couple of days after.

And just the question you put it. You got to fix some of money. Which would you prefer to do to give that money to people who don’t work or to cut taxes on people who do work? It’s not. I’ve advocated along with you, I think, was the abolishment of the payroll tax for a year and a half, same a dollar amount as the stimulus spending, same amount static revenue there, which you think would have worked better paying all these people money not to work or having no payroll tax for a year and a half on people who do work.

Jon Hartley: Or even a wage subsidy to some degree.

Arthur Laffer: you don’t even have to do that. Just, just cut the payroll tax. That’s a wage subsidy, if you want to think of it. Stop taxing wages, both employer and employee, and you’ll increase employment dramatically. The wedge will be different, just reduced.

That’s all.

Jon Hartley: Yeah,

Arthur Laffer: and that’s what we should have done. We would have never had the problem in 2008 when they had the, the Great Recession, as they called it. My, my, my solution to that back then was to have a complete cessation of all federal taxes for a year and a half, same dollar amount.

Can you imagine? No federal taxes, no payroll taxes, no capital gains taxes, no death taxes, no income taxes. All these. Get rid of all federal taxes for a year and a half, which is the exact same amount as the, as Obama Wama and Bushy Wushy spent on it, did that.

Can you imagine what would happen in this country if we had no federal tax at all? We, we’d be selling cars into central China you know, these guys all think that writing checks is the same thing as not collecting taxes. It’s not true. It’s totally different, Jon. And the Keynesians and the monetarists don’t understand that.

They really don’t. Milton Friedman, in the monetary history of the United States doesn’t mention income taxes. In 1930s, we raised the highest tax rate from 25% to 63%. On January 1, 1932, we shortened the brackets. We then raised it all the way up. In 1937, we raised it to 79% then we raised it to 94% in 1944.

Hello. Is it going to surprise you? But where is that in the monetary history of the United States? It’s not because that’s not where these people were focusing on then. And that’s what you and I and a bunch of others have brought back into the thing is the classical marginal rates of substitution and between labor and leisure.
And that’s what drives the system.

Jon Hartley: So, I’m with you. You know, I think there is this,

Arthur Laffer: I know you are,

Jon Hartley: you know, there, there’s this massive renaissance in, in fiscal research that I think shows that, you know, these fiscal multipliers, you know, are, are, are

Arthur Laffer: negative

Jon Hartley: statistically much lower, you know, close, much closer to zero.

Arthur Laffer: You’re not going to put them, they’re negative.

Jon Hartley: It depends on how you measure. I, I think to some, some degree.

Arthur Laffer: They made the mistake. If it’s not negative, they made a mistake in how they measured it.

Jon Hartley: Well, you do have to pay it back over time. Right? So like, you know, so there might be some positive effects in this year, but you will eventually have to do this with you.

Arthur Laffer: I’m going to do this.

Jon Hartley: So I want to, my last question for you, I think is an interesting one and one I want to talk about Trump policy for a bit.

But you know, 2018, you wrote the book Trumponomics with Stephen Moore and you know, you describe that, the Trump economic agenda, I think fairly well in that book. I’m curious, how would you. We’ve talked about the successes so far. I think we’re on the same page with the Tax Cuts and Jobs Act.

And you know, we hadn’t had a big corporate reform since the 1980s, since the 86 Act. And you know, in terms of the one Big Beautiful Bill, extending many of the items from the Tax Cuts and Jobs Act, making some of them permanent, full expensing permanency is terrific.

Josh Rauh, Kevin Hassett, myself, also Hoover fellows wrote a paper on this when it was sort of up in the air and I think we along with many others influenced some of that debate and permanence on at least for equipment and R and D. Those are permanent structures is now fully expensed that will be, is going to have to be renewed or will expire in a few years.

So but we’ve got most of the Taxes and Jobs Act which you obviously played a huge part in is, has been extended and many parts of it made permanent. Lots of evidence that we’ve shown that.

Arthur Laffer: It worked really well.

Jon Hartley: It influences capital spending capex and I think at some level, you know, it’s, it’s a shame that you know, we left corporate tax rates as high as we did for so many decades and it’s great that we now have full expensing like permanent full expensing like some other countries do as well.

So all good for incentivizing corporations to purchase property, plant, equipment, you know, that, that, that, that’s a boon for the economy. I’m just curious you know, what one, what remains left to be done in, in your mind one or what’s sort of the next in, in economic policy and in particular as it relates to tax policy.

And I’m curious also like know I think it’s fair to say that you know, the GOP has a lot of divided minds on, on economic policy these days. You know there’s you know, what some people call the new right. There’s folks like Oren Cass that very much rail against I would say your legacy, you know, the legacy of the supply siders.

Who talk about you know, Reagan tax cutting and you know, I guess JFK tax cutting and others. The Trump’s tax cuts as well to varying degrees unfavorably, and you know they’re I think maybe more focused on maybe redistribution. But you also have big proponents of tariffs. You have big proponents of, of say, you know, child tax credits, family policy.

You have big proponents of you know. Just. Of union policy and so forth and to really completely change the GOP’s economic policy to be less focused on, I’d say growing the pie for the entire economy and to be focused in certain areas. So I’m curious what you think about that shift.

I think those people are ascendant in the GOP. It’s hard to say how much power I think they truly have, but I mean I think they’ve had a lot of influence on not just President Trump, but in particular, J.D. Vance and I think Marco Rubio as well, I think it’s fair to say.

I’m curious what you think about that sort of internal split within the GOP

Arthur Laffer: based on data. They don’t make much sense at all in that stuff. I mean, I look at Trump, and I think he’s probably the most transformational president in US History. I mean, I tease him about Reagan all the time.
I mean, I say, you know, sir, Reagan got the highest rate, down to 28%. You’re stuck at 37. And he always said, but how we have fun in that stuff.

Jon Hartley: But he’s got a portrait of Ronald Reagan in the law.

Arthur Laffer: Who doesn’t? I mean. I think God has a portrait of Reagan in his office.
I mean, come on. But you know, if you look at it there, we have a couple of things to do on, on, on taxes. We, we do have a little bit to go to match Reagan low rate, broad based, flat tax. The one I did for Jerry Brown when he ran for president in 92.
But the one I think is the sleeper that you haven’t mentioned is health care price transparency. And that is a huge one, Jon. I think if you got some of your guys to work on that, that you post transactions prices so that people can make their decisions as to what their health care they want their health care to be, you’d reduce the insurance market dramatically.

You would make the system really efficient. Life Expectancy in the US has been declining dramatically over the last 55 years versus the OECD. Expenses have been going up all because no one knows what, what the prices are, the transactions prices. That’s a huge area and it’s about 17, 18% of GDP.

I’m talking to the President about this. In fact, he did a executive order in his first term on that. That I think is big. And I think what he’s doing is just super on that stuff. I mean, I don’t know, other than creating peace for the world in Ukraine.
Peace for the world with the Houthis. Peace for the World and 85 other conflicts, including prosperity for everyone else. Have everyone smiling and happy, having ice cream cones. I mean, this is the single most transformational administration ever. Reagan was amazing, I mean, really amazing. But Trump is just, my God, he’s gonna cure everything. And he is, in six months, look what he’s done.

Jon Hartley: No, it’s amazing.

Arthur Laffer: Energy decontrol. Have you seen what the results of that have been? I mean, wow. I mean, you know, and I think the left is shifting. I think they realize, I mean, when Hillary Clinton said that if he succeeds on the Ukraine Russian war, he should get the Nobel Peace Prize. What? Hillary said that about Trump?
How cool is that? I think the Democrats are going to be the newest, freest market. It’s like all the people we got from the Eastern bloc once the wall fell down, you know, once you’ve lived under communism, you want free enterprise all the rest of your life. And I think all the Democrats are going to love becoming really hardcore Trump Republicans. The Trump derangement syndrome is going to turn into the Trump love syndrome. And all of these. Gavin Newsom. My God. How can I, how can I, how can I follow my inner Trump? They’re all going to do that very soon. You watch the changes that these guys are making. They’re gonna become us, Jon.

Jon Hartley: We’ll see how Emanuel and some of these other dem moderates. I’m curious, any thoughts on, on the new Right and for those that are out there who are really going after your legacy and sort of the going after the supply side legacy, there have.

Arthur Laffer: Been mistakes made all over the place and, you know, incentives matter. And if you look at the research there, how can you get anything more than what I did with Brian Domitrovic and tax and Gene Sinkfield, by the way. And taxes have consequences. I mean, we’ve looked at every single tax return.
It’s not a sampling problem. We know the last guy in the top 1%. We know the first guy in the bottom nine. We don’t have their names, but we know how many dependents they have. We have all the data, everything there, it’s all from Saez, Piketty, by the way.

It’s all from the Institute of Inequality up at MIT. They’ve got great data. It’s just they don’t know how to use it. And if you look at it, every time we’ve raised the highest tax rate, the economy’s underperformed, tax revenues from rich have gone down and the poor have been hammered.

Every time we’ve lowered tax rates on the rich, the economy has outperformed, tax revenues from the rich have gone up and the poor have been provided opportunities and jobs and better lives. What more do you want? I mean, I’ve got all the other numbers in there as well.

I mean, I’m just talking about the, the inequality people. But who, who’s against poor people having higher incomes? Who on earth is against that?

Jon Hartley: Absolutely. No, I couldn’t agree with you more yet.

Arthur Laffer: And these guys are not using the data correctly. And they’re just me and I,

Jon Hartley: They definitely have a different social welfare function. I think that’s definitely.

Arthur Laffer: No, they don’t know data. And so they make assumptions that by taking for the rich you can help the poor. That’s BS. Excuse me, that’s bull poop. It’s not true. Whenever you try to take from the rich, you get less money.

You get less money, you have less to give to the poor. I would love to do a debate at Hoover if you guys wanted to sponsor it with Saez or Piketty or any of those. You just get it There, make it a Hoover Institution. We’ll make, make it two hours so we can get through the one liners and the slur, you know, the slurs and the slams and the sort of, you know, virtue, virtue signaling and all that crap and get down to serious stuff.
What did happen with the Tax Cuts and Jobs Act? What happened with the Kennedy tax cuts? What happened with the Reagan tax cuts? What happened with the Trump tax cuts? What happened with the tax increases under Hoover? What happens with the tax increases under Roosevelt? What happened with all of these?
We have those data. Let’s sit down and see what happened. What happened.

Jon Hartley: I couldn’t agree more. Now work on-

Arthur Laffer: I’ll come and do it, but you got to make it long enough so it’s not a, you know, it’s not a slogan slamming thing. I did this in UT Austin with, with, with Galbraith, Jamie Galbraith.

And at the end he said, Laffer you’re right. The 86 tax act was the best thing for inequality, the best thing for the economy ever. I mean, you know, they know they’re wrong. They just need to be shown it and with their data.

Jon Hartley: I, I as an empirical economist, I, I couldn’t.

Arthur Laffer: I know you are, you’re the best. By the way.

Jon Hartley: That’s very kind.

Arthur Laffer: Well, it’s true. And Kevin Hassett is the best. I mean you’ve got the greatest advisor in Kevin and you know, and Cogan too, by the way, that you’ve got some great people there at Hoover sponsor that debate.

And I’ll do it, and Saez can flop down from Berkeley. You could even bring my classmate with him, George Akerlof, bring him down with him. Bring Janet [Yellen] down. Let’s have a serious one on one mano e mano facts, let’s see what it is. Proposition we should raise tax rates on the rich. That should be the proposition. I say no, they say yes.

Jon Hartley: Okay, I really wanna thank you for coming on, this has been-

Arthur Laffer: I love it, Jon, I’m so proud of you. I can’t stand it. By the way, just I’ve known you for a long time. We’ve done work together. You are a great promising young man. One of my sessions with George was on the

Governor’s Council of Economic Advisors. And I think it was 2005. George Schultz, myself, Milton Friedman were there and I was complaining about something. I said, God damn it, I’m 65 years old and I’m sick. And George, who had this power over me that whenever he raised his voice it was like my dad, he scared the hell out of me. Arthur, stop right there. I said, I just want you to know that I still consider you a promising young man. And I looked at him and you know, I can’t stop from commenting on things.

So I looked at him and said, and I suppose that’s what Milton says to you, is it, George? He said, absolutely not. Milton never mentioned the word promising. Just great, I miss those days, I miss you guys. I miss California, but I don’t miss the taxes, I don’t miss the regulations.

I don’t miss the hostility. We here in Tennessee, if you drive by someone, you know, you’re driving your car and you see a car coming or a truck coming the other way, you go like that on the steering wheel, you know, in California it’s the same thing, but they use a different finger.

You know the hostilities you have there. In a state run organization, things are just really overbearing. Not only do we have lower tax rates, more prosperity, more in migration, less out migration, better education improvements and all of that stuff which we do, we also have less anger, less hostility.

Low taxes solve all sorts of problems. Stable money solves all sorts of problems. Deregulation solves all sorts. Free trade solves all sorts of problems. I mean know, government cutting government spending solves all sorts of problem. Low rate, broad based, flat taxes, spending restraint, sound money, minimal regulation, free trade, and then get the hell out of the way and let the economy solve its own problems.
They’ll do a lot better job than government people or people working in socialist organizations like Hoover. You are a socialist organization. Pay is not determined by how many students you get. Pay is not market driven. And I’ve never heard, I’ve never really believed anyone from a university can be a conservative.
You can’t be a conservative living in a socialist state and liking it. That’s my story and I’m sticking to it. Jon, you gotta get out into the private sector for a while.

Jon Hartley: The private sector, I agree, I’ve spent some time there and there’s nothing like it that’s more meritocratic than-

Arthur Laffer: And you enjoy life very much and thank you for having me, I’ll be waiting for your phone call to do that debate. Anyone you want, I’d be glad to do it.

Jon Hartley: All right, thanks so much, for coming on. This is the Capitalism and Freedom in the 21st Century podcast and official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy.

I’m Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Chris Waller, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is a live recording [on August 28, 2025] of an episode of the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group where I, Jon Hartley, am your host. I’m also a policy fellow at the Hoover Institution. It’s so great to have Federal Reserve Board of Governor Chris Waller here as my guest for this live episode at the Economic Club of Miami, which is also being live streamed on Bloomberg, Fox Business, and C-Span.

Chris, thanks so much for coming to Miami and for coming on the show.

Chris Waller: Thanks. This is my first podcast. I’m looking forward to it.

Jon Hartley: All right, well, first question. Let’s get started and maybe address, what some may say is the elephant in the room. Some of your colleagues [Lisa Cook] at the Federal Reserve Board are in the news. For those who haven’t been following the news, any comments on the status of this situation? I think there might have been a lawsuit dropped today or something like that.

Chris Waller: Yeah, when it comes to this, I, I really don’t have any comment. Things now are in the hands of lawyers in the courts. Not, not a poor, simple policymaker like me.

Jon Hartley: Okay. All right. Well, moving on to our first economic question really about the federal funds rate and where it’s going. You gave us a great economic outlook in your speech. CPI inflation now is both headline and core are about 2.7% year over year. It’s been below 3% for quite a while. Unemployment’s been around 4.2% for a while. And there’s still another non farm payroll report that still has to come up between now and the next FOMC meeting.

That could change a little bit. But the fed funds rate is currently at 4.25%. You said earlier that you’d like to see maybe a 25 basis point cut at the next meeting. Would you like to see more cuts at further meetings down the road? I’m curious, what’s your position on the trajectory of the fed funds rate?

Chris Waller: Yeah, that’s what I said at the end of the speech was I fully expect more rates cuts as the labor market continues to soften. Growth is probably still going to be slow in the second half of the year. And the tariff effects, any tariff path through effects will probably peak by the end of this year, beginning in 26.

So because monetary policy tends to work with these kind of long lags, you don’t want to wait and then you’re behind the curve. So my view is we should start getting ready, look through whatever price effects are happening right now. I don’t believe they’re going to be persistent.

I know I’m a bit of an outlier in the FOMC because of that. But this is exactly what economic theory would tell you. Look through the tariffs. Inflation will flatten out once the tariff effects are passed through and then we can continue moving on cutting to protect the, the real side of the economy.

But the pace and the speed. I like to give this example. I went to college in northern Minnesota. When I would drive home for Christmas, I knew exactly where I was going. But how fast I got to Minneapolis, depending on the weather and the weather’s like your current data in determines whether you can go fast, whether you gotta go slow, how much you can.

So that’s the kind of way I think about the rate cuts. We know roughly where we’re going towards neutral, but how fast we get there is going to depend on the data that comes in.

Jon Hartley: So you prefer a pace of sort of success, of potentially success of 25 basis point cuts, not a bigger 50 basis point cut or more at the beginning.

Chris Waller: Yeah. And it’s not a set sequence, it’s not 25, 25. That’s what I mean by the data. The data will kind of determine how fast we go. It could be a sequence of cuts, it may be a couple, then you may want to pause if the data is coming in in an odd way.

So that’s, that’s what I mean. How fast you know where you’re going, that’s the key thing. We know we want to head towards neutral. It’s just a question of how fast we get there.

Jon Hartley: So I’m, I’m a nerdy economist like yourself. I want to ask you, I want to ask you about r-star.

Chris Waller: Does anybody know what r-star is? No. [Laughter]

Jon Hartley: For those who don’t know r-star, it’s really the level of the interest rate where inflation’s either accelerating or decelerating. So it kind of tells you where are we at in terms of whether monetary policy is tight or accommodated. And so the fed funds rate’s currently at 4.25%. So if you thought that the r-star was much lower, then you’d say it’s a very tight stance of monetary policy right now. If you thought, well r-star was at about 4.25%, you would think that we’re at neutral. So I’m curious. One, there’s a lot of different ways in which people assess r-star. There’s model driven estimates, there’s a Laubach-Williams estimate that’s about 2.75 right now. There’s the Lubik-Matthes nominal r-star, that’s around 3.75 right now. These are nominal r-star numbers. I’m personally a fan of the survey based r-star estimates. The New York Fed has this survey, it’s called a Survey of Market Expectations. They ask Wall street types or hedge fund or primary dealers, market participants, what the Fed likes to call them and ask them what their estimates of r-star is. And you can take the median of that and that’s about 3.25 right now.

Source: Hartley, 2024. “Survey Measures of the Natural Rate of Interest”, Mercatus Working Paper

And that median pretty closely follows the FOMC median r-star estimates that are put in the summary of economic projections. We don’t get to see or know who the dots are. And these, the famous dot plots, Chris is one of them. But I’m just curious, sort of big picture one, where do you think r-star is?

How do you think about r-star? You’re a monetary economist. How do you think about formulating that in your own mind and sort of creating your own dot? I mean, do you follow survey based estimates? Do you follow model based estimates? Do you follow market based estimates, say long run interest rates and so forth? How do you think about it as a monetary economist?

Chris Waller: Well, so just the way I think about r-star is if the FOMC or the Fed, if we were hitting our inflation target at 2% and we were at maximum employment, where you’re, that’s your goals for the dual mandate and you’re hitting them and you’re sticking there and inflation expectations are anchored, what should the interest rate be?

That’s what we call r-star. It’s like what would it be if you were right on target and everybody’s expectations were anchored? The interest rate is composed of two parts. Some expected inflation which should be hopefully 2% if you’re on target, and some real rate of return. And the real rate of return used to be thought of as 2%.

So if you had a 2% target for inflation and a 2% real return, the nominal rate at neutral would be 4%. That was kind of standard wisdom for a long time in central banking. What we noticed about 10 years ago was this real rate, even though inflation was anchored pretty much around 2%, the real return on safe liquid government debt was falling from about 4 to 2 to close to 0 about 10 years ago.

So there was something going on that people were willing to pay more and more, a higher and higher price for safe liquid US government debt, which meant that the yield that they got was going down. So this is where this whole debate about r-star, it was falling, falling, falling.

It’s been very low. And now the debate is, is it going back up? Is it going to stay low? I know this is totally geeky. If I were sitting in the audience, I’d be shitting myself. But this is a serious problem for a policymaker and nerds like Jon.

So that’s kind of where we’re at. When I was saying 3% was a median estimate, that’s what I mean. Right now we think if he had a 2% inflate inflation target, the median FOMC member would think that the real interest, once you net out inflation effects, would be about 1%.

Which is significantly lower than 2% and certainly lower than about 4% early in the, in the mid-80s. The question is, is it going to continue? Is it going to start rising? And it was close to zero, it’s up to about one, is it gonna keep going or is it gonna stay there?

And that’s where a lot of energy research discussion has tried to figure out where do we think this is? And as Jon said, these numbers are kind of all over the place. If you even look at the FOMC survey of economic projections, they run from about two and a half to close to 4%.

So even on our committee that’s how big of the range is and how much uncertainty there is. So that’s basically the way I kind of look at it is it’s going to be a point estimate that moves around over time. And I gave a speech back in May of 24 at the Central Bank of Iceland where I gave a whole speech on what does it mean about r-star, why has it been falling, what did I think caused it and what do I think could cause it to go back up?

So if you’re really bored some night, go find that speech and give it a read.

Jon Hartley: That’s very enlightening. As a nerd, as a nerd, very enlightening for me, selfishly. I do wanna talk a little bit about inflation, but inflation during the COVID pandemic and I think a lot of people here probably remember this and I’m sure some people may still be upset about it, we did get cumulative inflation or a price level increase of 20% that’s permanent we haven’t reversed any of that.

I’m curious, what did team transitory, those at the Fed who thought that sort of inflation would come back down without fed funds rate hikes at the time, what did they get wrong? And I’m curious, should the Fed have started raising interest rates earlier than March of 2022?

I’m curious what your theory of the early 2000s inflation is. You know, was it supply induced inflation, demand induced inflation by say, you know, stimulus and so forth, supply induced by, you know, supply chains and so forth? Or was it a supply and demand induced inflation in your mind?

Chris Waller: Yeah, it clearly was both, I mean the whole COVID panic was a problem because it kinda hit the whole world. And then when everybody’s working at home or sitting at home, you can’t really produce stuff. So whatever’s being available out there, the prices start being dead up because everybody’s sitting at home with nothing to buy the goods.

So some of it was just the supply chains were restricted, we were all still buying. There was a lot of stimulus from the federal government and the Fed as well to try to support because we really thought this would turn out to be something like the great financial crisis where we have to step in and do a lock.

So you had both the supply side from supply chains, demand from supportive policy. And then the economy just recovered faster than I think we thought. So, I was on. throw all the knives you want, but I was on team transitory in 2021 because I gave a speech in May of 21. I said, look, what are all the reasons people think inflation’s going to go up?

And I walked through every single one of them and said, these are just price level effects. They don’t just cause prices to continue to go up and up and up and up and up. My economic reasoning just said it can’t happen. So that was, I think, a general belief that we had.

What happened is those price level effects turned out to be much bigger and much more persistent than, I know certainly I can’t speak about any of my colleagues, but for me it was a surprise at how big and persistent these changes were. And I gave a speech in Korea back at the end of first week of June where I kinda laid out what caused this persistence, what was it that caused all these things?

So I don’t want to go through a big ordeal about it, but those things which was like the COVID-19 it wasn’t just one wave of COVID-19 it was wave after wave after wave. And they weren’t synchronized around the world. So we would start reopening and somebody else would shut down.

And every time somebody shut down, they broke the supply chains and we still had a lot of stimulus money pouring in. Fiscal policy was very accommodative, monetary policy was accommodated for too long. And that also just led to more persistence in inflation. Now why is this important? Because from that experience we should have all learned our lesson that you don’t say the word transitory.

And what am I doing? I am saying whatever tariff inflation you get will be transitory. That was a pretty bold thing to say about eight months ago because everybody immediately said, you’re an idiot. But I think we’re now starting to see that tariffs are a very different thing.

It’s not clear how much is going to get passed through. It’s one thing causing it, it’s not multiple broken chains, fiscal policy monitor. So it’s to me very clear there’s really one thing we gotta worry about, those prices if there’s any pass through, there’ll be some. Once they pass through, it’s over and it won’t continue to cause prices to go like that.

So based on that long standing central bank wisdom is you just look through it. Just like if you increase the sales tax in every state, that would raise the price what everybody has to pay. But no one would say that’s going to just cause inflation go taking off.

And I doubt very much that workers would go to their bosses and say, hey, the city just raised my sales tax, I need a raise. I don’t think your boss pay any attention to you. But it’s weird with tariffs, that’s immediately what people start saying, tariffs, prices will go up and it’ll be more expensive.

Like I asked for a raise. Well, you don’t do it on the sales tax. You don’t do it if your income tax goes up or any other taxes go up. What is it special about tariffs in which you wanna act differently? So that’s kind of where I’m at.

I’m back on team transitory. We’ll see how it all works out. Some of my colleagues have some bets against me, but I’m sticking to it. That’s my line.

Jon Hartley: Very good. Well, I want to talk a little bit about Jackson Hole, where you were last weekend in Wyoming.

And there was a lot of discussion about Chair Powell’s speech, in particular on that framework review. So he, I think suggested last week that the Fed from a framework review standpoint was potentially returning to the sort of 2012 Bernanke symmetric 2% inflation target and kind of abandoning the so called flexible average inflation turn your fate regime.

That was adopted in the last framework review, that was in 2020 and sort of a brainchild of Rich Clarida. Any thoughts on the 2025 framework review? What do you think it should go? Where do you think the Fed should go from a framework review perspective in your mind?

Chris Waller: So for those of you again who are central bank geeks, a framework, we have a goal. Our goal is 2% inflation, price stability, which is how we define it, and maximum employment. Those are great goals. How are you going to get there? What’s your strategy? How are you going to act when the data isn’t getting you there?

So that’s when, when Jon says our framework, that’s what people, that’s how we interpret the framework. It’s our strategy for how we’re going to respond to the data to get us to these goals. That’s kind of the simplest way to explain what the framework is. Now, in our last framework, we had spent 10 years with inflation running well below our 2% target.

And you’d say, what’s wrong with that? Okay, maybe there’s nothing wrong with it, but inflation expectations started drifting down away from. From 2%. And so what that implied is our promise of 2% is not, is losing credibility, whether you like it at 2 or 1 or 0. But if you pick 2 and its expectations are drifting down, you’re losing credibility.

So there’s a lot of things that happened in the 2010s. We were at zero, lower bound. The economy was recovering from the financial crisis. The massive amounts of regulation went in after the financial, particularly in the financial sector, and all these things do nothing but slow down growth and put downward pressure on demand and prices.

So we took the 2020 approach, was like, we gotta get inflation and get closer to two. So the expectations come back up, our policies are more credible. And so one thing that people thought was when you say 2%, is it a ceiling where you’re happy if it’s 2 or less or you really mean it’s 2?

So if it’s been low, you let it run above. So on average you get to two. And that’s what Jon was saying, that was called flexible average inflation targeting. Meaning if we had been running below target for a while, we were willing to let it run above target to get it back to two.

That’s as simple as I can explain it. The problem is as soon as we adopted this policy of saying we’re gonna let inflation run above target, guess what happened? It went all above target, all by itself. We didn’t have to do anything. So the whole framework kind of got blown out of the water right away.

And so given that we’ve been above our inflation target for about five years now, it’s like, why are we saying we’ll let it run above target? Because it’s been running low, it’s not been running low. So we had to step back and say, look, that framework was too tied to the 2010s.

It was, to my view, I’m speaking for myself, it was too backward looking, it was too specific, it was too cute in a way of how we were going to manage things. Too discretionary, too much fine tuning. And I think we’ve realized, look, we want to go back, talk about our strategy, but do it in a more robust, less detail, less complicated way in terms of how we approach that is.

And that’s in the end, that’s kind of what the new framework does. It kind of goes back to where we were roughly in 2012. And we’re trying to make sure that whatever happens going forward, this is a robust framework.

Jon Hartley: Yeah, I think that sort of reflects, I think, a broad kind of consensus amongst economists.

That flexible average inflation targeting was maybe a bit of a misadventure. I want to talk more about the balance sheet for a second. So think quantitative easing, quantitative tightening. This is the Federal Reserve going out buying say long term treasuries and mortgage bonds and so forth that they started doing largely after the global financial crisis in 2008.

The Fed balance sheet’s now at about $6.7 trillion. It was at $9 trillion in 2022. How does the balance sheet factor into your thinking? And is a big balance sheet something that you think we’re going to have maybe forever? Do you think we could ever get back to reserve neutrality?

And where do you think the balance sheet is going in the future?

Chris Waller: Yeah, so I just gave a speech on the balance sheet about six weeks ago trying to explain what our balance sheet is, what are our structure of it, how should we, how should we structure balance sheet?

And I made the joke that most people would rather go to the dentist than talk about the Fed’s balance sheet. I see people starting to walk out already. So your audience. But the punchline is we have three major, I’ll do this all in like a ChatGPT version of the speech.

We have three major liabilities on our balance sheet. We have currency which is about 2.3 trillion. The Treasury’s checking account is on our balance sheet. We’re in the bank for the U.S. treasury. That’s about, normally it’s about $800 billion. So you’re up to about 3.1 trillion. And then we have a policy that we want to make sure banks have enough liquidity and reserves that we never have a panic where everybody’s chasing looking for loose coins in the cushions.

The banks always have the liquidity that they need. What the right amount of liquidity that the banks need is an open question. And right now we’re kind of staring at this and let’s say it’s somewhere between $2.7 and $3 trillion to make sure the entire banking system has the liquidity that they need so we never have to worry about running around chasing currency.

That means your balance sheet is close to about 6.2 trillion, 6.0, anywhere from 5, whatever, to of that. That’s a large number. It just sounds like a big balance sheet. And it’s certainly bigger than what we ever had pre global financial crisis. But the point is, even if we got rid of all the reserves, we went back to a scarce reserve, what we call the scarce reserve system.

When you had maybe only $25 billion instead of $3 trillion of reserves, our balance sheet would still be well over $3 trillion just from currency and the treasury checking account. So about half of our balance sheet side is out of our control. Really. Currency we print on demand.

And there’s a good reason for that. We never want anybody to doubt when they go to their bank and they want to say, I want a dollar bill that the bank says, I don’t know if I can give it to you because I don’t know if the Fed will give it to me.

The answer is we will always give you that dollar bill. Don’t worry about it. Make sure your customers know they will never have a problem getting currency if they want it. So there’s a good reason. We supply it on demand. And the Treasury’s checking account, you know, that’s gotta talk to Scott Bessent, that’s his decision of how big they want to carry a balance.

And just over time that thing has gone for maybe $25 billion 20 years ago, up to like $800 billion. Part of it is just the fact that we have much bigger government spending and bills have to be paid in a larger amount. And that requires and generally have a bigger balance in your checking account.

So in a nutshell, there you go. That’s the balance sheet. Enjoy. I hope you sleep well, Tom.

Jon Hartley: All right, very good. Tremaine will be sleeping safely at home knowing that we’ll have a big balance sheet for quite some time at least. So, debt and deficits. I want to talk a little bit about this because it’s something that gets talked about a lot.

So one, I think the debt to GDP ratio in the US has now passed 100%. There’s often criticism of continued deficits is more of a fiscal policy question than a monetary policy one. But in my mind, despite all the haranguing about debt and deficits, the 10-year yields maybe 4.2%, the 30 year yields about 4.9%.

They’ve been much higher in decades past. Do you think the federal debt is something that the American people should be concerned about? What do you think about?

Chris Waller: Yeah, so I mean, typically the thing is, is with deficits, we’re running about in the last few years and it looks like this year as well, we’re going to be running deficits of about 6 to 7% of GDP.

Typically that number should be closer to 3 to be what we would say as economists, as economists, what would be sustainable going forward. So if you’re running 6% deficits as part of your total national income. When I say gdp, it’s our national income as a group. You’re incurring a lot of debt given what your income is.

That’s what the debt to GDP ratio means. Now, the thing with the debt is it’s gonna be potentially paid off hundreds of years into the future. We can pay it off as a country. End of the life of the country in some sense. So you can spread out the repayment of that debt over decades, it doesn’t have to be all at once.

But you can’t just continue to run these kind of deficits for 100 years, 200 years. It just doesn’t quite work out. So, while it’s not of problem per se. Today it’s not on a sustainable path. And at some point they don’t have to be reined in. I don’t tell Congress how to either rein it in by cutting spending or raising tax.

That’s not my job. And I don’t, that’s, I leave them to do that so they don’t bother me on interest rates. But I mean that’s just, this is just kind of arithmetic. If you don’t get the spending deficit down, your debt’s going to grow, grow, grow, grow as part of your income.

And at some point markets are going to stare at it and say, look, I’m not financing that anymore, I’m going to, or I’ll finance it, but at a very high interest rate. And that’s what we’ve seen around the world when some countries get to very high debt limits.

The exception always being Japan. Japan has a 250% debt to GDP ratio and they have interest rates close to zero. So obviously something either people believe Japan will pay this off over a thousand years, they’ve been around for a couple thousand years. Maybe that’s their long civilizations are more tolerant of what they’re willing to incur.

So that’s just been a position I’ve taken. We’re not on a sustainable path. It doesn’t mean we’re in any kind of trouble now. But at some point we’re gonna have to get some sort of fiscal discipline and I will let Congress figure out how to do that.

Jon Hartley: One question, also non-monetary policy related question, really just on payments and I guess financial regulation.

So for those that aren’t aware, on top of managing monetary policy, the Federal Reserve also focuses on regulating banks, also managing the payment system. Chris spends a lot of time in his own capacity managing sort of the payments part of the portfolio. I’m curious, can you tell us what’s been going on in the payments space during your tenure and how things, how things have been changing?

The GENIUS Act was just passed. That changed a lot for stablecoins and that space. But there’s a lot going on in this space. Could you explain to the layman here what’s going on behind the scenes and what you’ve been working on in the Fed?

Chris Waller: Yeah, if you thought the balance sheet was boring, wait till you start talking about payments.

So I’m the payments oversight governor. I oversee the U.S. payment system. And 25 years ago if you’d said payments and who’s doing payments, you’d think of some guy in a green visor and a pad and a pencil. But it’s actually become one of the hottest tech jobs in the world because all of this stuff is moving into more technology and it’s being handled by non banks, fintechs, everything.

Stablecoins is a new form of a payment instrument that’s come about from the crypto world. Just cuz I said crypto, don’t get scared, it’s just a stablecoin, which is a promise. You give me a dollar, I’ll give you this digital dollar, and if you bring it back, I’ll give you your dollar back.

It’s really no different than a bank account at that point. I give a bank a dollar, I come back and ask for my dollar, they give me the dollar back. But what it does is it opens up a new set of payment rails in the US through the crypto world.

They don’t run on Visa, MasterCard, they don’t run on the bank rails, they don’t run on the Fed rails. And that just, for me, that just introduces competition in the payments world. And what that means is this should drive down payment costs for all of us so that we can make payments across each other, cross borders, cross everything at a much lower cost.

And my view is let everybody that wants to get in this business do it as long as they follow whatever regulatory structure we put in the GENIUS Act. Banks should be allowed, non-banks should be allowed, but it all has to fit within the clear regime that we set up.

The Genius act is a great start, but it’s never going to be perfect. Right out of the gate. We’re going to learn there’s going to be some issues, some problems, but we’ll fix them as we go. And that’s, that’s the critical thing. We’re not going to just shut everything down because we’re afraid somebody might lose a dollar or somebody might get scammed, somebody might lose money in their assets.

You just have to take risk. And that’s, that’s what we’re going to do. That’s how economy grows and gets better as you take risk. If you don’t want to take risk, you can become Europe. So sorry, my European friends.

Jon Hartley: Well, I know Miami, I think in many respects thinks of itself as the capital of, of crypto.

So, I’m sure there’s many in the crypto world who, who are very thrilled that you’re here and talking about payments and stablecoin issues. My last question for you is, is related to college football this week. College football is starting again this week.

Chris Waller: Oh man.

Jon Hartley: And it just so happens to be the case that Notre Dame is playing Miami University of Miami Hurricanes this week, actually here in Miami this weekend.

I know, Chris. I know you’re a big Notre Dame fan, as am I, actually. Any thoughts on this weekend’s game? I mean, how many points do you think Notre Dame will win by? And keep in mind here, you’ve got many Miami Hurricane fans probably in the crowd here, but any thoughts here?

Chris Waller: All I ever say when I’m in enemy territory, I just hope for a good game.

Jon Hartley: Very good. Very good. Well, Chris, I wanna thank you for coming to the Economic Club of Miami and for appearing in the special live taping of the Capitalism and Freedom in the 21st Century podcast.

I hope that Notre Dame does better than they did in the the finals last year and in 2012 when they played Alabama actually here for the championship then as well, which I think you were actually at.

Chris Waller: I was indeed at it.

Jon Hartley: It’s painful memories, but hopefully this weekend it’ll be a good game. But Chris, thank you so much for coming. This has been an amazing conversation. Thank you everyone for coming.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Cass, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast with Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy. I'm Jon Hartley, your host today. My guest is Cass Sunstein, who's one of the most cited legal scholars of the 20th and 21st centuries. He's a longtime professor at the Harvard Law School, where he's been since 2008 and previously was at the University of Chicago Law School since 1981. Cass also served as the administrator of OIRA, which is the Office of Information Regulatory Affairs during the Obama administration. He's also a prolific author of over 50 books, including Nudge with Richard Thaler and Noise: A Flaw in Human Judgment with Daniel Kahneman and Oliver Siboney. He's also the author of several famous law textbooks on constitutional law and administrative law. Welcome, Cass.

Cass Sunstein: Thank you. Great pleasure to be here.

Jon Hartley: So I want to just start by getting into your early life. Where did you grow up and how did you get interested in law and behavioral economics?

Cass Sunstein: I grew up in Waban, Massachusetts and I was a literature major in college. I got interested in law really my senior year in college, where I thought being a graduate student in English literature would be extremely interesting, but maybe too passive. And law, I thought you could have lots of flexibility and be more in the world.

That's what my young self thought. When I came to the University of Chicago a few years later in teaching, I was surrounded by rational choice types with Gary Becker and George Stigler leading the charge and Richard Posner and Bill Landes at the law school being the formidable giants who surrounded me.

I felt like I was 3 foot tall and they were all 9ft tall. I was a little person trying to understand. They were so high in the clouds I could barely hear their voices, though they were booming. But I was a literature major and I thought that their conception of humanity was not the same as what I had learned from James Joyce and William Shakespeare and William Butler Yates and John Keats.

And so I was skeptical, kind of cluelessly skeptical. I learned something about behavioral economics from Jon Elster, who was a Norwegian political scientist philosopher who came to the University of Chicago. He introduced me to notions about pre commitment strategies and about adaptive preferences. That kind of was an inroad into the behavioral stuff.

And I started writing material that drew on Thaler and Kahneman, Tversky, and it was, I think, primitive, was law professor primitive. But Thaler came to the University of Chicago at a time when I was immersed in behavioral stuff and that kind of accelerated. We became great friends. That's kind of accelerated my focus on behavioral economics and its relationship to law.

Jon Hartley: Fantastic, for the moment, I want to just focus on behavioral economics. We'll get to law and political philosophy later. So you co-authored the seminal book, Nudge, in 2008. I remember it as a pretty seminal moment for behavioral economics. And it really, I think, increased the popularity of behavioral economics. At the same time you sort of had the global financial crisis was sort of around the same time. But I just remember, you know, that really the, you know, late 2000s and 2010s was a very, very a popular time for behavioral economics.

He also wrote a book more recently, Noise, with Daniel Kahneman and Oliver Sibony. Daniel Kahneman being the famous Kahneman Tversky. I'm curious what you think about the state of behavioral economics is now following what I think has been just as sort of, I see it, I think, maybe a more challenging time for behavioral economics.

We've had some recent controversies, a lot of controversy, particularly in the field of psychology. A massive fraction of studies there aren't replicable. I think there's been some very famous scandals within the behavioral economics world, think Dan Ariely, Francesca Gino, Francesca. You've been in several of their papers have been retracted, following the uncovering from the folks at Data Colada.

And to me, I mean, it seems like behavioral economics maybe peaked around the times of the Richard Thaler Nobel and the Robert Shiller Nobel in sort of the mid-2010s. And maybe it's been on a bit of a decline. I mean, would you agree with that? Tell me why either that's wrong or where you think the state of behavioral economics is as we see it today in 2025.

Cass Sunstein: Okay, thanks for that. I'll tell you a story and then we'll maybe talk about something in the vicinity of data. So the story is I had dinner not long ago with a behavioral economist. And he said it's terrible. And I said what's terrible? And he said it's so terrible.

And I said what do you mean it's so terrible? And he said the demand for people doing behavioral economics is higher than it's ever been by far that people in the private sector, Silicon Valley and Saudi Arabia, in Germany, in France and Italy, are looking for people in the private sector who are trained in behavioral economics.

Governments are keener than ever that we're seeing interest in hiring behavioral economists from people who are running behavioral insights teams or nudge units. The demand is off the charts and it's higher than ever. And I said, why is it terrible? That sounds amazing. He said, there aren't enough people.

So the, the people are holding themselves out as behavioral economists or behavioral scientists to get jobs, but they're not trained. The field is flourishing with such, you know, kind of exuberance on the part of the people who are interested in it, and there just aren't enough people ready.

And he said, you've got to get people at Harvard ready to go help people who are thinking about smoking, secession or road safety or how to get people to pay fines when they're not paying fines, how to get people to take up programs, how to deal with occupational licensing.

So on the practitioner side, from government to the private sector, behavioral economics is incalculably better off than it was even six, seven years ago. On the academic side, the same is true. If you look at the leading economics journals, if there isn't at least one behavioral economics paper in the current issue, it's surprising if there isn't one the year before or the year after.

I'm sorry, the issue before or the issue after a year is too much. There are too many papers in behavioral economics in the American Economic Review, in the Economic Journal, and the Quarterly Journal of Economics. And some of it is kind of normal science where loss aversion is used to explain something, and loss aversion is identified in a context that we didn't see something might be appearing on default.

Default rules and their power. Benjamin Enki is doing work on complexity, which I find extremely interesting, and the role of complexity. There's a lot of work on cognitive scarcity. This is something that I'm keenly interested in from Mullainathan and Shafir, their work on scarcity and that has implications for when behavioral findings will be especially present and when they might fall apart because people are focusing on something and so they're not going to show loss aversion because if they do, they're going to lose a lot of money in a hurry.

So that's very vivid. John List, of course, has done a ton of phenomenal papers in the domain of behavioral economics. And if we don't see a good John List paper in any four month period, that's a surprising four month period. There's keen interest in both economics and in other domains in manipulation and how to think about it.

Sometimes it goes by specific names like dark patterns, or sometimes there's a specification of the exploitation of a behavioral bias. This also connects with work on algorithms and machine learning. So behavioral economics right now is both on the practice side and on the theoretical side in a better position, I'd say, by far, than it's ever been.

There isn't explosive insight period that we saw with early Kahneman and Tversky or Thaler, but we see much more in terms of insights and much more specificity and new insights coming that are often firmer, they might be consistent with, but firmer than anything we've observed before just because the techniques are better on replication.

Thaler has a new edition of The Winner's Curse coming out, I think in September 2025. And all of the findings replicate every single one. So that's, I think his exposition challenge in this amazing new edition of The Winner's Curse is not to be kind of crowing at the replication of the core findings, but they all replicate.

And to say they replicate is one thing to say the magnitude or the conditions under which, et cetera, like you can make the endowment effect go down or disappear if people are really sad, as I recall, you don't see an endowment effect, but the central findings of that defining book all replicate.

So within the field, by which I mean both practitioners and people are doing real academic work. I'm thinking of Alex Moss, whom I don't know, but whose work is very, very good. The fraud of Gino is a little like you're playing baseball and there's some player who took steroids.

I mean, baseball still pretty good sport and shouldn't take steroids and the fraud has hurt horrific. I, I don't even understand it. I should say I don't understand the state of mind suggests my limits as a behavioral scientist that I don't, I don't see how one could do that.

But that's clear with Gino and, and, but if you look at the, the extent of the field, fraud is horrific, but very limited in number. The replication challenge, as I'd, as I'd call it, I wouldn't call it a crisis. What's happening in Gaza is a crisis. Climate change, in my view, is a crisis.

The replication challenge, that's a better word than crisis, is if things don't replicate, that's basically an opportunity for learning. And the core findings replicate. We're seeing more, you know, more material that tells us more about when default rules will be powerful and exactly why you could say that a default rule won't be powerful if people hate the thing they're defaulted into and they have freedom.

Findings don't replicate. And that's, that's an advance to know that it's very important to keep at it to see, you know, is what are the boundary conditions for the availability heuristic. Stock trader probably isn't going to be vulnerable to the availability heuristic where they're going to lose a lot of money.

Jon Hartley: So this is kind of, I guess, how I see the maybe evolution of, like behavioral economics. You had like 20, 30 years ago, you had Kahneman, Tversky, Thaler, they were sort of challenging traditional models. They get into data, find some anomaly or some bias. Aha, yes. Some new behavioral biases are discovered.

And then you also had in the sort of two, maybe 2000, 2010s, a lot of work on behavioral finance and factors and things like momentum or herding, Jeremy Stein's hurting theory paper. You also had these things like Ernest Fehr's theory about fairness around that time. I think how it's evolved over time is now I think researchers are trying to find more of a unifying theory that connects these facts.

So things like I would say the complexity work, I would maybe put under that. I guess maybe more on the empirical side. I don't know if it's fair to say that, you know, RCTs and experiments, I think it's fair to say that they've certainly been the backbone, a backbone of behavioral economics.

I'm not sure if it's necessarily fair to say that every RCT or experiment is behavioral economics. I think some might disagree. And I think some of these definitions are very loose. But, you know, I think one challenge there is, you know, scaling. And I don't know, I've seen a lot of work that in my mind, like information provisions that maybe don't have significant results in that space.

But I'm just curious, like, I think one that behavioral economics, with things like default rules and information provision experiments, can't really hold a candle in terms of magnitude of the effects of these things. Is that right or wrong or. Obviously, behavioral economics is kind of meant to be the sort of third way, like idea into something very new.

I'm just curious what you think about scaling in behavioral economics ideas and implementation.

Cass Sunstein: Okay, so suppose we did an RCT and I put on my front lawn a sign that said don't smoke. And we had a population who drove past my front lawn and a population that didn't.

And let's. Suppose it's a big size and it's. Let's just go with the idea it's randomized and the diminution in smoking was zero. That this would be a test of a pretty pathetic nudge and whether it worked to diminish smoking in New England. And I predict that the effect would be zero.

Or we could design in a cafeteria in Palo Alto or in Cambridge, an intervention where there was a notice contains meat with respect to meat products, which would be to nudge people not to eat meat. And I have no prediction about the effect of that. But I wouldn't be surprised if the effect of the nudge was small or zero if we had a randomized trial.

So the number of nudges is so large, just like, like the number of criminal punishments is so large and the number of medical interventions is so large that if you took a class and called them criminal punishments throughout, let's say, western history and the effect size of the punishment was really small and some populations are zero, that wouldn't be amazing.

And if it turned out that across a category of medicines, the effect in diminish, diminishing fatality or illness was really little, and that wouldn't be surprising if the. I hope medicine's much better now. But if you look at medicine over the course of human history, you probably get a median effect size of zero.

So I think the meta analyses of the effect of anything is imperfectly informative. So I would predict, and we have reason to think that default rules are the most powerful nudge. And there's a paper that's a meta analysis by Elke Weber and others which shows the average or median effect, I forget which, it's 26%.

That's very large. But even that I want to be very careful with. There's a paper by Todd Rogers and another that finds a shift opt in to opt out creates over 90% increase in participation in use of an educational technology. And there are default rules that sometimes have very limited effect.

And there are things we'd want to have. We want to use data like this to build up a theory of when a nudge has an effect. The question does the average nudge have an effect? It's kind of a crazy question. It's a little like the question, does the average increase in civil penalties have an effect?

We need to know what's the increase from and to. And what kind of civil penalty is it and do people even know about it and what's the affected population? So then we'd build up an account. I'd love it if we'd have more precision than we now do about which nudges have what kind of effect.

As a first approximation, architectural nudges have a larger effect than educative nudges like labeling or reminders. But even the category of labels and reminders, it's, it's too broad and too coarse. If you have a label that says with a smiley face, this has GMOs. I predict that will have very little effect in diminishing people's consumption of GMOs.

If you have something that is a graphic warning for cigarettes, it wouldn't be at all surprising if that had a significant impact on smoking secession.

Jon Hartley: So I guess, you know, we had this. I think one of the biggest things that came out of all the interest in it was created and I think maybe most famously in the United Kingdom, I think this might have been during the David Cameron government that, you know, the idea was, you know, you would create a team within a government that would essentially advise on behavioral matters related to policy.

I think also around the same time, you and Richard Thaler were also big advocates of this idea of libertarian paternalism, this idea of having choice architects. The idea of incorporating behavioral findings into policy, I think was a very new thing at the time. This was around maybe 2010 or so.

I'm curious, what's the legacy of those groups like the original Behavioral Insights Team or the so called Nudge Unit in the UK? I think it's been spun up, but there's now groups in many countries that are helping to advise governments. I mean, what have been sort of made the largest contributions from nudges in that space with advising and working with governments?

Cass Sunstein: It's a great question and it would be worthy of a long academic article or book. And there are pieces that try to catalog those things. I'll give a couple of examples. In the United States, there's a program called Direct Certification for School Meals where if you're poor and the school knows you're poor and you're a kid, you're directly certified, meaning you don't have to apply.

And at one count, something like 10 million children were benefiting from nutritious free lunches and breakfasts to which they were entitled. And the Direct Certification program was something in which they participated. So that's millions of kids getting to participate in school meal programs by virtue of the shift from opt in to opt out.

Another one that is not a product of any particular nudge unit, but which is a product of behavioral economics research, is green by default. So we're seeing people who are automatically enrolled. This is a big program in Switzerland, as I recall. It's big in Germany. It's big in Southern California, where people are automatically enrolled in green energy.

They can opt out, go into coal if they want, but that has very large effects in reducing pollution, including greenhouse gas emissions. And in some places it leads to higher electricity bills. But people aren't opting out. So that's kind of a big legacy item. In the United States, people are, whenever they buy a car, it has a camera in it that where you can see behind.

And this was a rule I got to be involved in. It's not, it's. It has a nudge component that is you're nudged to look at the camera and to avoid smashing into a small kid or a dog or something physical and strong that'll batter your car. So it has a strong behavioral nudge feature in it.

The mandate itself of the cameras and the cars is a mandate, not a nudge. But it was very much, I can attest, behaviorally informed by thinking about limited attention on the part of drivers. And there are people, including very little people, not because they didn't grow, but because they’re children who are not dead because of that.

And that's a, you know, very significant policy intervention. Dick Thaler would refer to automatic enrollment and retirement plans. And that's kind of the most visible, I confess, because I never want to retire. And the idea of retirement gets my system, one that is the intuitive automatic system in the brain sad.

The retirement one isn't the one that comes first to mine for me, but is true that automatic enrollment in retirement plans is a big deal, but there are 1001 uses of automaticity. The OECD now has a big project on sludge audits, reducing administrative burdens of various sorts.

Now, you can think of sludge as a problem even if you have no interest in or enthusiasm for behavioral economics. But the fact is that sludge route of behavioral economics, the concept and the concern about the adverse effects of administrative burdens on, like, entrepreneurs or innovators, or on people who want to build things like build housing, or on people who are seeking access to employment or other opportunities.

Sludge is devastating, often because of behavioral characteristics of our species.

Jon Hartley: I guess. Speaking of nudge units and regulatory policy, I sort of want to segue into your time at OIRA. So during the Obama administration, you led OIRA, which is the Obama administration's, I guess, chief regulatory rulemaking sort of oversight function.

And during this time, I think you certainly were described as a pioneer and someone who'd held the role. Some folks, like, I think Richard Epstein, said that because you're one of the more conservative folks in the Obama administration. But one of the ideas that you champion, I think, was this idea of a regulatory budget.

And some people were calling this regulatory money ball, I think, at one point. And I think it's something that really, actually was truly adopted in the first Trump administration and that they really followed this idea that every new rule that it created, for every new rule they create, they would delete a rule.

Cass Sunstein: Okay, so the idea that I was very enthusiastic about and certainly didn't originate was in his cost benefit analysis. So the idea of careful analysis of the costs and benefits of regulatory options, including alternatives to the proposal that is being offered to the American people, seems to me essential.

And you can, and many economists do, like cost benefit analysis, who have no interest in behavioral economics. The idea of cost benefit analysis outruns behavioral economics, was pioneered by people who were not particularly keen necessarily on behavioral economics or didn't know what it was. But I like behavioral economics because it is a corrective to behavioral biases which people in government, either because they're human or because they're responsive to people outside government, are subject to.

So you might think, I heard of a case in which a risk came to fruition. There ought to be a law, let's regulate that. But it may be that the case was an outlier, very rare, and that the costs of regulating outrun the benefits. So cost benefit analysis as a foundation for every environmental rule, every highway safety rule, every food safety rule, I really like that idea.

There may be cases where it's challenging to quantify, but the economic Constitution of the United States, I say, should and does have cost benefit analysis at its heart. Let's distinguish that from a regulatory budget. The idea of having a ceiling on the cost of regulation in a year, I don't like that idea. The regulatory budget idea is one to which I'm opposed. I get it, but I don't like it. The reason is if you have a regulation in a year, let's say, that costs $5 billion, and then you have three others that cost $8 billion, now we're up to $13 billion in cost, and then you have four others and the cost is starting to get really high.

That might be horrific depending on what you get in return for them. If you get in return for them $100 million, it's a catastrophe. You shouldn’t do that. But if you get in return for them $100 billion in benefits, then go for it. So cost benefit analysis, hooray. Regulatory budget, a kind of sympathetic and respectful boo reaction.

Cost benefit analysis right now isn't riding as high as I would like to in the US Government, and the reason isn't running as high as I would like is that the Biden administration didn't, let's just say, put cost benefit analysis at the foundation of its regulatory policymaking.

It had environmental and other goals that I hoped were broadly compatible with cost benefit balancing. But it wasn't, because cost benefit analysis was in the driver's seat. And in the Trump administration, the deregulatory efforts, some of which I applaud, some of which I don't like so much, the deregulatory efforts seem to be founded on a policy commitment that is not grounded in empirical analysis of costs and benefits.

So the regulatory budget idea I'm not for. I don't like the idea of one regulation in, 10 out. I think that's random and a gimmick. If you have a year where you have three regulations out and 500 in, that might be a good year, depending on their content.

If you have a year with three regulations in and 500 out, that might also be a good year, depending on their content. What we want is careful cost benefit assessment of existing regulations. And we did that in the Obama administration, at least for starters. I would applaud the current administration if it did careful assessment of existing regulations in terms of cost benefit analysis in deciding whether to get rid of them.

And you'd get rid of a lot of them if you did cost benefit analysis of whether they made sense. So there's a happy alternative universe which I hope will arrive at, in which the regulatory state really is a cost benefit state.

Jon Hartley: I think one of the other things you were an advocate of in the first or in the Obama administration, correct me if I'm wrong, was occupational licensing deregulation, meaning that workers can take their license from one state to another.

Don't have to take additional new exams. You know, say a nail technician in Maryland can also work in Virginia and doesn't have to get an entirely new license. This is a huge challenge for people that move a lot. So, you know, spouses of folks in the military that are moving quite frequently and if, you know, they're a licensed worker, they often have to get relicensed, which is a huge tax and huge burden.

Curious what you think about all the progress on that.

Cass Sunstein: I'm upbeat. I think it's good. So occupational licensing, you're right, is something that I was very concerned about in government. And the fact is it's a drain on economic growth, on entrepreneurship, and on individual opportunity. So there's an old liberal idea.

By liberal, I don't mean left of center. I mean the liberal political tradition of careers open to talents. That's the idea. And libertarians tend to like it. Many progressives like it, too. And careers open to talents. It's a beautiful idea. It was a little bit boring, maybe in the 1980s because it seemed.

Yeah, of course. What else have you got? But it's not boring now. Where careers open to talents isn't something that. Is a lived reality for too many people. So the idea, if you're licensed in Arkansas, you get to do the same thing in Mississippi. A presumption in favor of that seems to me a really good idea.

Unless there are unique conditions in Mississippi such that the Arkansas license doesn't warrant that license, or unless there's something wrong with these original states licensing policies. Now this could be an opening through which you could drive a truck. But I, I want to start by saying there's a strong presumption in favor of reciprocity.

Jon Hartley: It's fascinating. It's amazing to see how much strides that have been made in occupational licensing. It's an area that I, I work in and sort of tracking these trends across states and, and across countries and, and I mean the US in general, at least from some of the work that I've done in a forthcoming paper with Morris Kleiner, is that the US actually has some of the most stringent occupational licensing regulations.

At least if you were to measure the fraction of workers that have a license compared to many other countries is very, very high compared to say, Europe. So it's interesting that you would think sometimes that we have a very dynamic economy in the US but there are all these sorts of barriers that exist.

Not saying that we don't need some licensing for doctors and certain professions are important, but to what degree do hair braiders and nail techs have to be licensed and so forth? Dog walkers and so forth. It's certainly an interesting topic that's made a lot of headway in recent years.

Some people might say it's still small compared to other macro things, But I'm with you in that I think it, it's more important than people realize. I think maybe about 25, 30% of the workforce has a license or so, and it's really substantial and it's used toward those people who are generally in lower incomes.

And so it's really, I think, one of those policy ideas, you know, occupational license deregulation that can actually improve opportunity for lower income individuals and help improve their productivity. So I'm with you there. I want to sort of segue into legal philosophy. You spent a lot of time, time in your career teaching law classes across a variety of fields.

You, I think, spent a lot of time working on administrative law. I just was curious, how would you describe your judicial philosophy? I kind of understand you're a judicial minimalist. You're sort of an advocate for maybe more executive and administrative decision making or more intelligent administrative decision making.

You're a fan of experts, broadly speaking. And you recently wrote a book, Law and Leviathan: Redeeming the Administrative State with your Harvard Law colleague Adrian Vermeule. Tell us more all about your judicial philosophy.

Cass Sunstein: Okay, so there are a couple things I like. If there's the idea at a highest level of abstraction, the idea is deliberative democracy.

So a deliberative democracy is something associated with the German philosopher Jurgen Habermas. John Rawls has endorsed it. James Madison was a deliberative democrat in economics. Amartya Sen is an enthusiast for deliberative democracy. At Stanford James Fishkin is a fan of deliberative democracy. And the basic idea here. We'll get to the judges in a moment.

Is that a well functioning constitutional order combines accountability and responsiveness. That's the democracy part of deliberative democracy, with a commitment to reason giving and deliberation among people who are trying to figure things out. That's the deliberative part of deliberative democracy. So we don't have a government by referendum.

The right to instruct was rejected by the Constitution's founders on the ground that it would destroy the point of the meeting. They're supposed to deliberate with one another and figure out what's best. So deliberative democracy will naturally lead, lead to some enthusiasm for technical expertise. If you're trying to figure out how to handle road safety, intuition won't be enough.

The deliberative part requires a commitment to getting really empirical. And I see the administrative state at its best, not as it always exists by any means, as continuous with the founding commitment to a deliberative democracy. Okay, in terms of the judges, we want a judicial role that's alert to the ambition to a deliberative democracy.

And we want courts respectful of the processes of deliberative democracy and we want them attuned to ensuring that it doesn't misfire. So the most important thing the Administrative Procedure Act does, maybe is to authorize courts to strike down agency action that's arbitrary. So if an agency says that we're going to deem the social cost of carbon to be 500 because that's really big and the climate crisis is upon us, that's arbitrary.

That's not reason giving. If you say we're going to deem the social cost of carbon to be zero because we think climate change is not real, that's almost certainly arbitrary. I think the almost is just I'm being very careful here. We have to figure out what the grounding is for the administrative state doing one thing or another.

So arbitrariness as a very bad thing is consistent with the aspiration to a deliberative democracy. A democracy that's not deliberative might be arbitrary, but that's a form, I say, of authoritarianism, which runs afoul of the founding era's ambitions to have a deliberative democracy. Okay, then there's the rule of law.

So the book Law and Leviathan is about what the rule of law entails. And here the idea is that the rule of law has an internal morality where, and this is Hayek is an inspiration, at least in my mind, for this, that if you have a rule in the world that isn't on the books, that's not the rule of law.

So if. If in reality the enforcement officers are acting inconsistently with the rules on the books, that violates the internal morality of law. If the law is changing so rapidly that people can't plan, that's inconsistent with the rule of law. If there's retroactivity, so people do things that are fine by legal requirements in 2025, but then in 2027 they're punished that it runs afoul of the ban on retroactivity.

If people can't understand what the law is, if it's too vague or confusing, that's inconsistent with the. The rule of law, the morality of law. Now, if you have no redistribution or lots of redistribution, that might be good or bad, but it has nothing to do with the rule of law.

At least it doesn't until we specify what the legal sources. But you can do lots of stuff consistently with the rule of law. Still, the rule of law is. Central and a foundational part of the restrictions, as they should exist and frequently do exist on the operation of the administrative state.

In terms of the Supreme Court's role, I like the idea of the judges avoiding very ambitious theories and avoiding very ambitious, broad rulings. So there's some people on the left and some people on the right get excited about maximalist rulings where the court, you know, strikes down a bunch of things or adopts a theory of liberty or equality, and bam, our country is now being ordered to do all sorts of stuff.

I'm skeptical of that. The idea of judges being theoretically humble and ruling in ways that are agnostic about what liberty and equality really means. They don't have expertise on that. And it's a pluralistic society, after all. So being theoretically modest and also ruling narrowly on the case, these are presumptions.

These aren't edicts. But ruling narrowly rather than broadly, I like that. So here I stand with Chief Justice Roberts, who says, if it's not necessary to decide an issue in order to resolve a case, it's necessary not to decide an issue when we're resolving a case. So that's a plea for a form of minimalism, which, whether or not it's good in art, is usually pretty good for the Supreme Court of the United States.

Jon Hartley: I'm curious, I guess, on the topic of both the courts and deliberate democracy. I'm curious how you think about our current system and how much it has maybe strayed from how the founders maybe envisioned the sort of original Madisonian form of government. And maybe, you know, you think it's important that for it to have changed since then.

I mean, we now live in a world that's very, very different from the time of the Founders. Certainly from a national security perspective, we have nuclear weapons and so forth. But I'm just curious, you know, there's this, I would say, criticism of the current sort of state of affairs or the current regime in saying that, well, you know, Congress doesn't make laws and tries to avoid.

To deliberate. Now they don't want to decide these big issues that it's really their responsibility to decide. And then what ends up happening is they give a lot of power to the administrative state that decides a lot of things, or the presidency, the executive that decides a lot of things, and then they do things, and then sort of it goes between the executive and the courts, and the courts kind of are being forced to weigh in on these things that perhaps Congress should be weighing in on.

I'm curious what your thinking is about the, the current regime and how the current powers, you know, three branches of government work together compared to sort of Madison's original vision. And, and how do you think it should be, how you think it should function?

Cass Sunstein: It's great. It's complicated. So let's take two stabs at it. There's a grand narrative out there which your question can be taken to press, which is that we've seen successive breaches of Article 1, Article 2 and Article 3 of the Constitution. Article 1 insofar as Congress grants broad discretionary authority to the executive and administrative entities, violation or breach of Article 2 insofar as we see independent agencies exercising authority outside of the presidency, that's on the run in current constitutional law.

So the idea of independent agencies is no longer secure. It might be gone pretty soon, but it's been around since 1935. And then there's a third breach of Article 3 where a lot of adjudication is done by the executive agencies. You're putting a Spotlight on Article 1. I don't think the grand narrative is right, but I think.

But I'll get to something kind of adjacent to it that I think is right. If you look at the founding period, a lot of discretionary authority was given to the executive and to agencies and the constitutional concerns were either absent or very occasional. So the breadth of grants of authority to the executive pursuant to open ended words like reasonable is pretty eye opening in the founding period.

It's not like Congress made all the decisions and so, okay, and said to the executive, okay, do what we just said. Instead Congress said do what's reasonable or appropriate, things like that. So there's real continuity between the first, second Congress and first and second Congress and what we now observe, the idea that independent agencies are constitutional affront or barnacle, that's also hard to defend.

Independent agencies were around in the founding period and it looks like most people then thought that was constitutionally fine. The adjudication issue is a little more complicated and the magnitude of adjudication done by the administrative state now is very plausibly out of accord with constitutional expectations. Okay, there's all that.

It's clearly the case that the breadth and ex magnitude of executive branch authority was not expected. And I think it's less because there's discretion than the number of domains in which discretion is exercised. And the power that discretion is exercised with respect to way outruns the founding period.

So if you think of the EPA or the Department of Transportation or the Social Security Administration or the Federal Communications Commission, or the Federal Trade Commission. My gosh, they're doing all sorts of stuff that at the founding, the national government wasn't expected to do. The Department of Labor.

So whether this is an affront of the Constitution is, I think, not at all clear. Because what part of the Constitution does it violate is a very fair question. It's not clear it violates any part of the Constitution, but it's very different from what was anticipated. Now, this is a large question.

No modern industrialized society looks like the founding era or 40 years after the founding era government. So we're not seeing that in Canada or France or Italy or Germany. Not that any of those is perfect. But the idea that we would have a small national government akin to that of, let's say, 1830, that seems cray cray.... So that's cool person talk for crazy. I'm trying to be a cool person. So failing, evidently. But the, the, the mission of trying to discipline the administrative state by reference to the rule of law and to cost benefit analysis, including elimination of administrative burdens and barriers and sludge.

That's a really honorable mission.

Jon Hartley: That's fascinating. I guess you just maybe broadly. Thank you. Here, just about political philosophy and liberalism, you've written quite a bit about political philosophy as well, in particular about liberalism. In 2023, you wrote a New York Times essay titled Why I Am a Liberal.

Does the term liberal mean a whole lot anymore? I'm just curious. There's everything from economic liberals to social liberals. Many who I would say are firmly in one camp and firmly not in the other, which traditionally I'd say would be a key distinction between maybe Republicans and Democrats, at least from the 1980s through maybe 2016.

I'd say it would probably go back even further, maybe even pre the time of Buckley and others in maybe the 50s. Now, Locke also talks about a lot about moralism in book four of the An Essay Concerning Human Understanding. And certainly I think it's fair to say that the founders believe that morals writing about “Nature's God” and the “Laws of Nature” in the Declaration of Independence. So I think there's some today, namely the post-liberals, that might characterize them as libertarians and as social liberals. But, you know, I think that's somewhat ahistorical and untrue. And I mean, they also were in favor of tariffs as well. So, you know, I think calling them full economic libertarians I think wouldn't be true either.

Now, they certainly believed in property rights. That was something that was foundational. And they certainly believed in fighting the excesses of government. They were fighting very small taxes by compared to the taxes today. And that in part started the American Revolution. Economic liberalism, especially protected property rights, has been responsible, in my opinion, for enormous amounts of economic growth. And maybe there's some unintended consequences of that. But I'm curious, what does it mean to be a liberal today as you see it? And are there limits on liberalism as you see it, if any?

Cass Sunstein: Okay, so a liberal today believes in freedom and pluralism and the rule of law. That's a triumvirate, a holy trinity. Freedom, pluralism and the rule of law. Ronald Reagan was a liberal. Barry Goldwater was a liberal. Barack Obama is a liberal. Franklin Delano Roosevelt was a liberal. So this is a big tent. Hayek was emphatically a liberal, no question about that. John Stuart Mill, also Robert Nozick for sure. John Rawls, definitely Susan Okin, Stanford's political scientist, no question at all. So I have a book coming out in just a couple weeks called Liberalism in Defense of Freedom and, and I almost called it Big Tent Liberalism. Now, the disagreements between Susan Okin, for example, and John Rawls are fierce. The disagreements between Robert Nozick on the one hand, and Joseph Raz, a philosopher who was a liberal, died not long ago. Those are also fierce. But pluralism, freedom, and the rule of law are a shared set of convictions. I think it's. It's like, really important for those who are part of the liberal tradition to stand up and say so, even if they disagree, you know, very fiercely with people who are also part of the liberal tradition.

So I feel, right now, I'm not a libertarian, but I feel libertarians are my brothers and sisters. I worked in the Reagan administration as the Department of Justice. I had some serious, serious disagreements with President Reagan, but, you know, my. My intellectual sibling and commitment to liberalism. So this might not have seemed as important 30 years ago as it is now, but given what's happening in Russia and China, in various parts of the world, given the illiberal left, which is sometimes not that excited about freedom of speech on campus or elsewhere, not just the Marxist left, but the illiberal left, given the illiberal right in Hungary, for example, where the idea is a democracy, that's illiberal, I think it's an oxymoron, but we understand what the sentence means.

To put a spotlight on freedom, pluralism, and the rule of law as composing the liberal tradition is a big step forward, and it may be, you know, of. Of great importance in the next 50 years.

Jon Hartley: Well, Cass, I really want to thank you for coming on. This has been an amazing conversation, and you've had such a prolific career. It's a true honor to have you.

Cass Sunstein: Oh, an honor to be able to talk to you. Thank you.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy.

I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Ms. Truss, which is hosted at the Hoover Institution Economic Policy Working Group

Jon Hartley: This is the Capitalism and Freedom in the Twenty-First Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy. I'm Jon Hartley, your host today. My guest is Liz Truss, who served as Prime Minister of the United Kingdom in 2022, as a Tory MP from 2010 through 2024, where she served in a number of cabinet positions in various Conservative governments, including Foreign Secretary. She's also most recently the author of Ten Years to Save the West. Welcome, Ms. Truss.

Liz Truss: Great to be on the show.

Jon Hartley: Well, I want to start with your early life and it's a real honor to have you on here. You were born in Oxford. Your father was John Truss, who's a professor of mathematics at Leeds.

And you also studied at Oxford, like many British Prime Ministers, and you studied philosophy, politics and economics. I mean, at what point did you first decide that you like politics and economics and that you actually want to do this for a living? Was this something that was just destined, given that you were born in Oxford, or was this something that you came across over time?

Liz Truss: So I was always quite interested in politics, and politics in the 80s was very interesting and exciting and of course there was a big battle between the US and the USSR who was going to win the Cold War. And my parents were on the left wing side of politics and my mother actually campaigned against nuclear weapons. She was pretty anti-American actually, and certainly anti the policies of the US administration at the time. I think one of the first political people I heard about was Caspar Weinberger, which must be quite unusual for a child growing up in the 80s in Britain. And when I got a bit older and I saw what was actually happening and the role that Mrs. Thatcher successfully played in bringing to an end the Soviet Union and bringing to an end the Cold War, I sort of thought, well, actually, disarming wasn't the right strategy.

It was the right strategy to actually call out the Soviet Union, talk about how there was a huge problem. It was obvious when the Berlin Wall fell and all the people were trying to get into the west, it was obvious that the Soviet Union was not an aspirational model of the world.

Yeah, I think my mum in particular was slightly misty eyed about what happened, even though she'd spent a year in Warsaw in the 1970s. So she knew perfectly well that the model didn't work. So that's, I guess, my first exposure to politics and talking about politics. And then I joined the Liberal Democrats and people were saying, why did you join what was not the Conservative Party? But the answer is my parents were very left wing and almost being a liberal was the acceptable face of being right wing where I was in Leeds at the time. And it was only really when I got to university and met Conservatives that I decided I was a Conservative and I joined the Conservative Party.

Jon Hartley: That's amazing. And yeah, I feel like certainly college and universities can be one of those, I think, transformational periods, I think for a lot of people and discovering sort of what they believe in, that's quite interesting. So I take it that Thatcher has sort of been your North Star for you from the beginning.

Liz Truss: So I think the thing that really sort of started me on the road to being on the right of politics was actually experiencing what happened at my school. I went to a comprehensive school in Leeds, which is in the north of England, and it was very politically correct.

There were lessons on racism, there were lessons on sexism. And I just thought, this is a load of rubbish. Why are kids being taught about this stuff when some of them in the school weren't actually very good at reading and writing? And that was my first exposure to kind of left wing ideology.

And it was that that really put me on the road, I think, to being a conservative and wanting to live in a country that was successful, not a country that was just making excuses the whole time. And the places I grew up so Paisley in Scotland and Leeds in England, frankly, their better days were behind them.

They had been pioneers of the industrial revolution. They'd been huge manufacturing hubs and they were now full of disused factories and derelict buildings because they'd lost a lot of their purpose. And I just thought, why does it have to be like this? So it was more being in quite a left wing place and just thinking, these left wingers, what are they actually talking about?

Their solutions don't seem to work. And when I got to university and started studying economics and I almost arrived at economics by accident, I'd actually gone because I was interested in politics. And the degree course was politics, philosophy, and economics. So economics was a bit of an afterthought once I started studying it and saw everything from free trade to how free markets work, I've begun to understand why it was that these places that had been so successful had been competed out of business.

The policies that the British government had adopted of nationalizing industry, this is, I'm talking about the sort of post-war Attlee government hadn't been effective. And I became very concerned about Britain joining the Euro because which was being pushed by the labor government of the time, because I could see that having a sort of free floating currency was one of the ways that a country could actually adjust its economic policy.

So all of those things I then started to learn about and I built that worldview.

Jon Hartley: Well, I think it's rare for, I guess, politicians in general and members of Parliament to be numbers oriented. Obviously you grew up in a family where you have some very amazing mathematical minds in your own family and doing philosophy, politics, economics and working as an accountant and doing all these things.

I feel like that's just a rare skill set for politicians in general. And I mean, it does seem like there was, I guess this rift in the late 80s too, between the Thatcherites and John Major and the role of UK in Europe, I think was a big part of that and the Euro was a big part of that break.

So to me, I see that as sort of being one of these key moments, also setting Hong Kong on the course that it's been on. So I guess, fast forward a good number of decades later here, you come in as Prime Minister in 2022, you have a firmly pro-growth agenda at the outset of your premiership and you wrote a book, in fact, ten years prior called Britannia Unchained: Global Lessons for Growth and Prosperity. So I think economic growth has been something that I think is always been front of mind for you, is my sense. You co-authored this with four other Conservative MPs, including your Chancellor Kwasi Kwarteng. And I'm just curious one, can you describe to me, I guess, what this growth sort of thinking and plan has been for a long time?

Obviously you've been thinking about it for a long time, but how badly in your mind does the United Kingdom need pro-growth policies and sort of a revamp on economic growth? We can talk about what's going on now and the Starmer premiership, and many things are going in a worse direction, in an opposite direction.

But I'm curious what's been your vision as far as growth in the United Kingdom over the decades going into your premiership?

Liz Truss: Well, so the reason we wrote the book is we felt that Britain was on the wrong track, even though at the time we were junior backbenchers in a Conservative government.

So we felt that the policies the country desperately needed weren't happening. And that is why we wrote the book. Looking at how do economies actually succeed, what does it take? Cuz Britain was already stagnating. It was already stagnating by the 2010s. It had been going on for some time.

You could argue that it really started in the 1990s with the coup against Mrs. Thatcher. That's where it started. But that is only the recent history of Britain's economic failure. In fact, it goes way back to the end of the 19th century, the development of the permanent bureaucracy, the failure to really take on the Americans and Germans in manufacturing.

Britain was a country that led the Industrial Revolution. But the fact is that we got overtaken, and we got overtaken due to a variety of factors. You've talked about the lack of politicians who've got numerical skills. I could make that more general point across the population, Britain is not done enough to compete in areas like manufacturing.

Even though we've had great universities, we've not been good at translating that into economic success. And what we've had is a very, very powerful bureaucracy. We've had elements of socialism in our country for a very long time. Of course, those were introduced at the start of the 20th century.

But if you look at the Attlee government nationalizing huge swathes of industry, creating the National Health Service and the welfare state, we're now in a position where the British government is spending 45% of our GDP. And even, back when we wrote the book Britannia Unchained, it was still up in the high 30s, it's now got even worse since then.

And at the same time, we've just got huge levels of regulation on our economy. Partly that is driven by our membership of the EU, where lots of regulations were added, but a lot of it is domestic. The Town and Country Planning Act makes it pretty much impossible to build anything anywhere in Britain.

We've got incredibly expensive house prices. Our energy costs are four times what the energy costs are in the United States, partly because of the environmental agenda, partly because fracking has been banned. But on every possible measure, we are economically very uncompetitive and we now have the fastest rate of millionaires leaving the country of any nation in the world, apart from China.

But what I'm saying and what we say in Britannia Unchained is the seeds of that are very longstanding in Britain. It's a cultural issue. There's an anti success culture, sort of. We call it the tall poppy syndrome where he tallest poppy gets cut off an entry, an anti-entrepreneurial culture.

So if I'm to compare us to the United States, there's much more of a fail fast culture in the US and people respect people that build up businesses. I think that's less, less true in Britain. So these were all the things that we were trying to address. And it does go back to what I was saying about the places I grew up in.

I want to see them be successful. I think it's incredibly depressing. A country that's declining and living in a country that's economically declining leads to all other types of decline, whether it's high crime rates, drug abuse, social unrest, all of those things result or are correlated with a poorly performing economy.

So to me, that was the number one issue that we, we had to deal with.

Jon Hartley: Absolutely. And yeah, I mean, it's amazing to see what's happened to the UK over the decades. I mean, obviously World War II UK being bombed out, I mean, had a huge impact on Britain's growth trajectory and the US in many respects overtaking the UK is having the world's reserve currency become the world's largest economy, in the post war period being almost half the world's GDP at that point.

Obviously, many other players are, are, are growing now, China and many others. So I wanna talk about early in your premiership we have on September 23rd, your Chancellor Kwasi Kwarteng delivered a ministerial statement titled the Growth Plan and it proposed to reverse an increase in the corporate rate increases that were scheduled, also a cut to the personal income tax.

A proposal to essentially implement many of these I think great ideas aligned in Britannia Unchained and really I think a pretty standard sort of pro-growth agenda, like in the US largely, in part deficit finance, then all hell broke loose.

Liz Truss: If I could cut into this deficit finance thing, that it wasn't deficit financed.

The fact is the deficit in Britain was huge and the debt was huge. But my view was if we'd done nothing, taxes would have gone up because that had been legislated for and taxes going up were actually going to result in a worse deficit because certainly over a period of five years.

And a lot of independent economists agree with me on that, that if you raise corporation tax so much, you damage economic activity, businesses stop, stop opening and companies leave the country. Which is exactly what's happened. And it's the idea it was deficit financed as opposed to all of the spending increases which have now been allowed under the Labour government.

That is a leftist talking point and it's a point that's being used against me. But I would argue that what we were doing was not deficit financed. It was actually creating the growth would have helped pay off the deficit. Now that the policies I put forward were not implemented, we've got the counterfactual and the counterfactual is the debt has gone up.

So it wasn't deficit financed.

Jon Hartley: Yeah and I think I'm with you in that the media portrayed a certain narrative that was incorrect at the time. And I think a lot of economists had sort of gone back to this period. And there was this big spike in 30 year gilts that moved from 3.5% to 5% in only a few days.

And I think in hindsight now, I think a lot of economists now look at this as in part being sort of a confluence of factors. So things like liability driven investment strategies, employed by pension funds, because they have to match the duration of their liabilities, even a small jump in guilts can be sort of accelerated by pension funds that are now forced to sell their UK government bonds.

And also you had sort of this auction at the same time. And so something that probably would have been a routine small jump in government bonds was really exacerbated. So I'm just curious, how do you think about these sort of other facts in terms of what was going on?

Liz Truss: I think there were various things going on, but the fiscal package I announced was smaller even by the Office of Budget Responsibilities numbers, which I don't necessarily agree with. But it was smaller than the fiscal packages Rishi Sunak announced and it was also smaller than the fiscal packages Rachel Reeves have announced since.

So there is something about the way that the mainstream media and the economic establishment in Britain view public spending as opposed to tax cuts, i.e. they're much more willing to accept the idea that whereas they don't accept that tax cuts are inevitable or need to be done. So there's a asymmetric attitude by what I would describe as Keynesian economists which now dominate the Treasury, the Bank of England, the Office of Budget Responsibility.

And what has happened in Britain is that those entities have acquired a lot more power. So Gordon Brown made the Bank of England independent. They used to be under the control of the Treasury. He put the Civil Service Code into law. So it made it much harder, in fact, impossible to hire and fire bureaucrats.

He also, this actually happened under George Osborne. The Conservative Chancellor created the Office of Budget Responsibility, which is a bit like an extreme version of the Congressional Budget Office. So essentially those bodies were making judgments about economic and fiscal policy that I believe should be political judgments, but were made by those bodies.

And those bodies have a very, very clear worldview. And it's the same as the worldview taken by the IMF, taken by the Democrat Party in the United States, taken by the World Economic Forum. Public spending good, tax cuts bad. And this is why, despite the fact Rachel Reeves has announced policies that are much larger fiscally, they've been on the spending side.

So that's entirely acceptable to these people because they like big government. So that was one factor, the sort of bias in the system and the group think in the system that was pro Keynesian. And that's been building up for many, many years. Essentially, since the successful supply side of the policies of the 80s, that kind of worldview has been building up.

And I think that if you look at the backlash Donald Trump has faced in the markets from economists, it's the same worldview that has become prevalent and we need to defeat that. And I think Scott Bessent is doing a very good job of making the argument for supply side policies.

But separate to that, there was an issue, unbeknownst to me, taking place in the markets themselves, and you referenced it. These LDIs that pension funds had invested into, they were essentially a leveraged product that depended on interest rates being low in perpetuity. Now, of course, they weren't going to be low in perpetuity.

They were artificially low. Ultimately, interest rates had to rise and those funds were caught short. It created a run. And what happened is the Bank of England, which is meant to be responsible for financial stability, rather than ensuring financial stability, used the opportunity to try and push the blame onto the mini budget for what was happening was in fact their failure to properly regulate the pension funds.

And that was very difficult for us because we weren't aware of the LDI issue at the time. We were blindsided. And subsequently the Bank of England themselves have admitted that two-thirds of all the gilt spikes that took place after the mini budget were actually downed to LDIs. So they've admitted that two-thirds of the market movement were essentially their fault, but they've only admitted that last year, long after I'd been removed from office.

So you had a situation where there was a very strong group think in favor of one sort of economic policy. And I tried to upset that, I tried to disrupt that because I felt that was the economic policy that had led our country to decline. But the second thing was that there was a tinderbox in the market that I wasn't aware of.

And the Bank of England and others tried to blame me for their mistakes.

Jon Hartley: I totally agree with you in the sense that one, I mean, there has been this enormous rise in new adherence to Keynesian economics, especially I think, since the Great Recession and the global financial crisis in the late 2000s.

And what's interesting, too, is for all these people who say that Keynesian multipliers are very high and that in some cases that government spending somehow pays for itself, how is it the case that debt to GDP ratios around the world continue to rise in advanced economies in the way they have, right?

And so to me, I mean, and if you look at a lot of, I think, good empirical work done by economists, including the Hoover Institution, by folks like Valerie Ramey and others, the Keynesian multipliers ultimately are much lower than they actually are in reality. And that doesn't mean that there can't be some stimulus during recessions.

But I think what it does sort of pink bears that it's ultimately not a growth plan and that if there is going to be some spending during these good times or bad, that just government spending tons of money isn't going to cause some economic boom like many seem to think, including, the current Labor government and many others.

And I think, too, would really sort of, I think, strikes at court as well. Maybe this is just a characteristic of our age is just the desire to lay blame on others. I think, the Federal Reserve in the US still won't in any way acknowledge the role that maybe how late they were to raise interest rates in 2021, 2022, might have made inflation worse.

It's just very much a, “oh the inflation came from elsewhere”, and had nothing to do with all the stimulus-

Liz Truss: Absolutely, I mean, and this is back to the point I was making about the bureaucracy. The bureaucracy has become increasingly empowered and Central Banks are the ultimate case of this.

And the fact is they've failed. Inflation has been rampant, it's been particularly bad in the UK, interest rates were raised too late. We had massive quantitative easing essentially to pave the way for all of this public spending. Keynesian economics hasn't worked. We've ended up with massive debts. And I think the Federal Reserve is more part of the American political dialogue that there is talk of ending the Fed, the Fed being part of the problem, in Britain there is less scrutiny of the Bank of England, and that needs to happen because you've got a system where the bureaucracy has gone unscrutinised, they've failed and they're not accountable. And I think in order to get the economic policies we want, which are supply side policies, small government policies, those types of policies, we have to change the role of central banks.

I think they have become a big part of the problem.

Jon Hartley: Yeah, and at some level it's interesting how independence of Central Banks, which I think is an important, in a real thing, in the sense that-

Liz Truss: The word independence, when something's independent, independent from what? And what it's become is independent from blame or accountability, that's what they've become independent from.

And ultimately institutions that aren't accountable to the public or aren't accountable to market become a problem. And I think that fundamentally, in Britain, we had a better system where the Treasury and the Chancellor were accountable and then the Bank of England was accountable to them. The system worked, we moved away from that and our economic problems have got worse.

Jon Hartley: Yeah, whether you think it's research or discussion of green monetary policy, or how central banks can solve issues of race or other things like that. It's not to say that these aren't important issues, obviously.

Liz Truss: This is institutions getting captured, because if they're not accountable to the public, they start to become accountable to NGOs or lobbyists or people with the loudest voices.

And you've had the green fashion or the DEI fashion, and that has taken over the thinking of these institutions and they've lost sight of what they're meant to be there for. The Bank of England has two jobs. One is financial stability, which it completely failed to deliver in October 2022, and the other is keeping inflation low, which it completely failed to deliver.

If the head of the bank of England had been a politician, they would have been sacked long ago. And that shows you that there's massive problems with the incentives in the system.

Jon Hartley: And I think, I want to get into the media a little bit because I think the media plays a role in all of this at some level.

I think the media does tend to hold water for a lot of these, say, bureaucrats. I mean, could you imagine how different the narrative would have been if, say, Trump was in power in the 2021, 2022 inflation period and imagine inflation similarly jumped. How would the media characterize inflation then?

And I think rather than painting it as a picture of, it's all supply chains coming from elsewhere, I think they would have blamed Trump in the same respect that they're trying to now look at tariffs and try and sort of look at inflation prints and tie them together and maybe tariffs will cause some one time price impacts.

But I guess the point is, to me it seems like the media is obviously biased and the mainstream news obviously biased and obviously, I think has played a huge role in all of this, I think, including especially in your premiership. I think the media obviously went berserk and were relentless and I think, to be honest, in my opinion, were quite unfair and never really gave your premiership a chance.

You coined the term anti-growth coalition to describe sort of resistance from unions, the media, environmentalists, the parts of the Tory party. I'm just curious, obviously real GDP has been flat for a decade and a half in the UK. What are the major institutional roadblocks in your mind to reignite economic growth in the UK?

I'm just curious, what kind of obstacle do you think these groups play in realizing a true reform kind of vision? Obviously, the Labour Party's in power now, so the opportunity for pro-growth reforms has perhaps even been further diminished. But I'm curious, thinking long term 20, 30 years, what sorts of institutional roadblocks need to change in order for there to be any hope for growth in the UK?

Liz Truss: I mean, on the media, I think part of the problem is, yes, they are biased or the mainstream media is biased towards the left and they're also biased towards state institutions because they have kind of permanent relationships with civil servants, state institutions which are quite undermining, I think, of people trying to change the system.

So system change is not something they like. They want to keep the status quo. And the other thing is the media has just got increasingly trivial. So whereas there would have been detailed analysis of economic policy, if you watched a political show in the 1980s, the expertise has been hollowed out.

So it's much more of a coverage of a pantomime who's up, who's down, who's plotting against who, soap opera than it is real analysis of the issues. So I think there's two different problems. One problem is their bias, but the other problem is they're shallow. And that makes it very difficult for people like me who want to change things fundamentally about our country, because having those serious discussions is extremely hard.

Who are the vested interests? I mean, the bureaucracy itself is a massive vested interest. The government's spending, almost half of GDP. Those are people's jobs, their livelihoods, their future careers. Of course, they don't want to see that system dismantled. Of course, they don't want to see transparency over what they're doing.

Of course, there's also all of the NGOs, and there's been lots of talk about the Soros Network and the World Economic Forum, but there are a lot of organizations funded from groups outside the UK who are lobbying for policies. So this Labour government, they said that they want to build more houses and Britain has a massive problem with housing.

In the 1940s, Attlee introduced a piece of legislation called the Town and Country Planning Act, which basically socialized land in our country. So it's very difficult. So Labour wanted to make some minor changes changing environmental laws. There's been a massive backlash from the environmental NGOs and now they've stopped that.

So this means you can't build something because there might be a bat there or there might be a newt there, all those kind of things. So it's a combination of the bureaucracy, the NGOs, the big corporations that benefit from state regulation. The people receiving the green subsidies or the people getting the DEI money or all this kind of stuff.

So there's a whole bunch of people. And what I think has changed about Britain and America is the elite is now left wing. The elite are those people, they tend to live in the big cities, they talk to each other, they work in the media, they work in the big corporates, they work in the bureaucracy and they want to protect the system.

Whereas it's the working people who their jobs have, gone because the country's de-industrializing or they can't run their small business because there's so much red tape. It's those people that want change. And this is what I was talking about when I was talking about the anti-growth coalition. It is those vested interests, it is the people who have that political power at the moment and ultimately that entire system needs to change.

I watch what's going on in America and I see that Donald Trump is trying to challenge those types of vested interest.

Jon Hartley: I want to talk a little bit more about the Labour Starmer government. I'm curious, where do you see the UK now under the leadership of Keir Starmer, who's been in power for-

Liz Truss: We're heading for bankruptcy is what is happening.

Jon Hartley: Well, I'm curious they've passed a number of radical changes. On the tax side, they've abolished non-dom and are now going to start taxing profits outside the UK. I think for a long time, the UK and London has been a very business-friendly place.

I mean, I think for people around the world to do business there. And I think there were some questions or concerns maybe around Brexit for a short period of time. But I think those were largely smoothed over, and the banks have largely stayed in the UK, but I think this is a pretty big sea change now, actually taxing profits from outside the UK.

The Starmer government's also proposing to lower the voting age from 18 to 16, not to mention all this spending and so forth. I mean, what is the path in your mind? I mean, it's interesting to see how quickly they've, I think, lost some of their popularity in the polls.

But they've got another three years at least or so. I'm curious, where do you think the country is heading and what hope do you think there is here?

Liz Truss: I think it's important to note that things were bad even before Labour got in. That's why I tried to do what I tried to do because we had a huge debt, we were spending vast amounts of money, taxes were the highest level for 70 years.

So things were already bad, and Britain was getting less competitive. And the reality is that post financial crash we have been the slowest country to recover from the financial crash in terms of GDP per capita. So there is a fundamental problem with Britain's economic model. We're not competitive enough, our energy isn't cheap enough, our taxes are too high, our welfare state doesn't work.

The many problems that we discussed in Britannia Unchained still exist. But what Labour have done is they turbocharged it, so made it even worse by abolishing non-doms, by putting up taxes, everything from VAT on private schools to making it. They're introducing a new Employment Act that will make it much harder to employ people.

They're just making everything worse. And the reason is that they believed, and this is partly what happens when you have a media that doesn't really tell the truth. They believed that the reason Conservatives were failing is because of austerity, because we weren't spending enough money, which is absolutely ludicrous.

As I've said, the reason the country wasn't doing well is we hadn't had enough economic growth. So they believed their own publicity. They believed that if they got into power, spent a bit more money and were nice to the bureaucracy, everything would be fine. And in fact that hasn't worked.

They are extremely unpopular. They will be voted out of office at the next election. It's not just on economic issues as well. We've got huge problems with our criminal justice system, with two tier justice, a failure to stand up to Islamism in this country. The public are extremely concerned about where everything's going.

And I wasn't joking when I said, I think there will be some kind of fiscal collapse. In the 1970s a Labour government had to go to the IMF for a bailout in 1976 because the country was stagnating. There was high inflation and they were not able to fund government debt.

And I think that is the situation we could be in in pretty short order. And the Labour Party MPs are not willing to vote for spending cuts. They rejected some welfare reform that was proposed by the government. So unless there is some kind of miracle, it's hard to see how the show stays on the road.

Jon Hartley: One thing I think that probably strikes a lot of Americans do, I think have a pretty good sense of the First Amendment rights and right to free speech. And there are very strong protections in the US, unlike in the US, the United Kingdom never has had a strong written constitution which is hard to change.

Liz Truss: We did have the Bill of Rights in the first place, I think, 1689.

Jon Hartley: In Canada, where I grew up, we have a constitution as well as a Charter of Rights and Freedoms, but it’s not a strong constitution and has an escape clause (the notwithstanding clause). But I guess in all these cases, you just don't have the same kind of protections that you do with sort of in the same way that the US constitution that is hard to change and where the courts are given judicial review.

All these additional separation of powers, sorts of things that you don't really have in a parliamentary system, are additional checks on government. Do you see this as sort of this maybe global challenge across the Anglosphere, where in Canada, the UK, Australia, New Zealand, without the strong constitution, you don't have the same sort of protections to things like free speech as you do in the US? I mean, I think of things like Speaker's Corner, which obviously is meant to, there's a number of things that I think in UK that sort of are old messages trying to celebrate these sorts of things.

But now if you listen to say, Vice President JD Vance's speech at the Munich Security Conference, and you see these issues where people are being arrested for political films or people are being arrested for praying in protest of certain things. Those aren't the sorts of things that I think you see in the US regularly.

And I'm curious what your thoughts are on the state of free speech. And these are other sorts of property rights protections and other things that may be weaker in the UK and how does that get resolved if at all in UK in your mind?

Liz Truss: The underlying principle of the British Constitution is parliamentary sovereignty.

And we do have a Bill of Rights and we did put in place free speech. The problem is that since then legislation has been passed which has removed these rights and been done by a majority in Parliament. So what needs to happen in order to restore the British Constitution to what it was is to repeal those laws.

It's as simple as that. And you're right, it's harder to change things in America. So it's harder to get rid of the First Amendment or it's harder to change things like the Supreme Court, in Britain it's easier to change them, but it means there's less long term protection.

So what I'm saying is, particularly under the Blair government and since we have seen the judiciary become unaccountable, we've seen the Bank of England become unaccountable, all of these laws have been passed, these laws against free speech have been passed. Like online harms legislation, those need to be repealed, but they can be repealed through an Act of Parliament.

The problem is we don't have a government that wants to repeal those things. And this is why there is such a massive disconnect between the public and the government and the elite that run the country. But there are other similar issues in America. If you remember, I mean, Hillary Clinton was arguing for the First Amendment to be changed.

There are plenty of people like the woman who I think is now being defunded but runs the public radio, she was saying that she didn't believe in free speech. So those forces are there in Western societies. They're fundamentally anti-democratic forces, they don't want the public to have a point of view.

But I think in each country the battle needs to be fought in a different way. And of course the US has the First Amendment, we have our ancient British liberties. The problem is they've been covered over with all this terrible stuff that's been legislated in the past 40 years.

And what we need to do is elect a government that's going to restore the historic British constitution.

Jon Hartley: I guess, my question when I think of Tocqueville a lot and the idea of the tyranny of the majority, could UK even elect a government that could really restore these sorts of freedoms?

And I guess that that's the one challenge sometimes with some majority type governance where it only takes 51% of the populace to agree to kill the other 49%, right? And so, an extreme obviously, but I guess, that's the one sort of beauty of the US Constitution where it's protecting individual and minority rights or instances of people where the majority is against.

Liz Truss: I think the US Constitution is a very good document, don't get me wrong, I think it's a good constitution. That's not to say the United States does not have issues with things like the Supreme Court, and there's no perfect constitution. But you asked would British people vote for it?

Answer, 52% of the British public voted for Brexit, that they are prepared to vote for more big change if it is clear what they're voting for. So I think the problem has been, and this is why the Conservatives did so badly at the last election is the Conservatives were not clear what they stood for.

And in fact the Conservative Party is deeply split about what it stands for. But I believe a proposition to restore the British Constitution and give British people back the freedom of speech is incredibly popular and people would vote for it.

Jon Hartley: I guess, I'm curious what the path forward is in your mind to get to a place like that and who the standard bearers will be, leading that charge sort of out of where the UK is right now on a number of these sorts of fronts, both economic and legal.

I mean, I'm curious, you've got the UK Conservatives, the Tories being led by Kemi Badenoch now. And then you've got the Reform Party UK being led by Nigel Farage, they only have four seats currently in Parliament, and Nigel is one of the four. But in just the past few months, mid-2025, the Reform Party is polling ahead of both the Labour Party and the Tories.

I'm curious, obviously the Tories are still very divided and I think, you put it this very well to me once where, you said that, basically one half the Tories just have a completely different sort of view than the other half. And I'm curious, where do both these parties go from here, and who do you think is going to emerge victorious in the next few UK elections?

Liz Truss: Just in terms of the Conservative Party. The two parts I'm talking about are essentially. Do you believe in the sort of the globalist agenda? Are you in favor of the international institutions like the European Convention on Human Rights? Are you in favor of net zero and pursuing environmental policies?

Are you in favor of transgender ideology? These are some of the touchstone issues. Or are you more in the nationalist camp? You believe in Britain as a nation state. You don't believe in following the sort of the international human rights rules that mean that you can't deport illegal immigrants etc, etc.

That's the split in the Conservative Party. And in fact, I think you saw something similar in the Republican Party between the more Trumpite Republicans and maybe some of the more old school Republicans. So it's exactly the same split that I think you see in US politics is now happening in British politics.

And essentially there needs to be a realignment because there's one bunch of voters and I talked about them, the people who voted for Brexit, the people who don't believe in transgender ideology. They want to see the country re-industrialized. They're not environmental fanatics who want to ban fracking, etc.

And that is what is happening. But the process of that is messy and who knows exactly how it will turn out before the next election. But what I'm convinced about is that the sort of Trumpite forces in Britain, and we didn't really have an equivalent of the Tea Party.

And I think it's interesting what happened to the Tea Party and the MAGA movement. But the Trumpite forces in Britain, I believe, will win eventually and will coalesce. But we're still going through that process of what you might politely call a debate.

Jon Hartley: You've written this book Ten Years to Save the West.

Liz Truss: Here's a copy of it live here.

Jon Hartley: Very good. Well, I want to give you an opportunity, I'm just curious, is there in your mind at some level, what is the real risk in your mind, what happens if this coalition isn't successful?

I think growing up in Canada, there was certainly a lot of hope for, I would say pro-growth Conservatives and I'd say maybe a similar sort of similarly minded Conservatives that Pierre Poilievre would win this election in 2025. And because of a whole host of reasons that didn't happen.

And the Liberal Party of Canada is now entering its fourth government and is continuing, a number of things, but it's a little different, but largely a number of the same things. It's largely the same people who populated the Trudeau government. I'm just curious, Ten Years to Save the West is certainly a very serious title.

I'm curious, what is your main argument in the book and why is it so important that the people act now?

Liz Truss: What we're facing in Western societies and Anglosphere societies are internal enemies who essentially want to undermine Western civilization, whether it's importing masses of illegal immigrants, whether it's pursuing Keynesian economics to the destruction of the economy, the environmental agenda, while China and India are busy building new coal fired power stations, making our energy completely unaffordable.

And it's interesting, Greta Thunberg, who's really the poster girl of these people, has gone from campaigning on the environment to campaigning to be pro-Hamas. It's a collection of Islamists, green zealots, big state people. And you can see that that was what the Biden administration were doing with things like the IRA, spending masses of money, focusing on identity politics and transgender ideology and Black Lives Matter and all that kind of stuff.

And meanwhile, our enemies, China, Russia, Iran, North Korea are working together to take on the West. And that's what I mean by we've got ten years because we need to get our economic and cultural strength back and be proud of Western civilization. Otherwise, we will see a combination of those forces, the most potent of which is China, dominate the world.

And the particular threat in Europe is the threat of Islamism. And this is another force that is currently being unchecked and it poses a threat to our way of life. So these are the forces that the west collectively needs to take on. I think Donald Trump winning in the United States last year was an absolutely key part of the fight back, but we now need to fight back in Europe as well as the US because the US will be incredibly isolated if Europe is taken over by those forces.

Jon Hartley: I'm curious, just what particular common interest on China. Because I think China is the one that's really changed in maybe the past ten years or so. And really the world being now eyes wide open to various human rights abuses. And also I think, particularly with the UK what's happened to Hong Kong?

Hong Kong being previously governed by the UK and it was, I think, one of Margaret Thatcher's biggest mistakes with the Sino-British declaration and in sort of handing over Hong Kong when it arguably didn't really needed to be completely handed over. But I'm just curious, what is your take now in terms of, I mean, obviously Taiwan is being threatened by China.

I mean, where do you see the United Kingdom playing a role in? Certainly it's been taking a number of Hong Kongers who've wanted to leave Hong Kong and giving them BNO, British National Overseas status. I'm curious, where do you see the UK playing a role in a world where China's on the rise going forward?

Liz Truss: We need to be resisting the efforts of China to infiltrate our country. So, for example, the Chinese have a plan to build a massive embassy in the center of London with huge capabilities. They've been warned against it by the US, these are the kind of things we shouldn't be doing.

We shouldn't be allowing the Chinese to take over our media or our critical infrastructure. There's evidence that that is exactly what they are seeking to do. And ultimately the UK and Europe, the best way of fighting back against sort of Chinese dominance is by making our countries more economically successful and less dependent on China.

I mean, I've criticized Keir Starmer through this interview, but one thing I'm pleased he did is sign a trade deal with the US, we need to be working more closely with our allies and we should be avoiding economic integration and spying and intellectual property theft from China. But the reality is of the way the world works at the moment that ultimately is the United States that has to form the main bulwark against Chinese dominance.

Jon Hartley: I couldn't agree with you more. Ms. Truss, I really want to thank you for coming on. It's been a huge honor.

Liz Truss: Great pleasure. Good to be on.

Jon Hartley: It's been an amazing conversation.

Liz Truss: Thank you.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy.

I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Richard, which is hosted at the Hoover Institution Economic Policy Working Group

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Today my guest is Richard Epstein, who's one of the most cited legal scholars of the 20th and 21st centuries.

He's a longtime professor at the University of Chicago and New York University Law School. He's also the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution. He's also the author of many books, including his Magnum Opus, the Classical Liberal Constitution, released in 2014. Welcome, Richard.

Richard Epstein: It's great to be here. Thank you so much for having me, Jon.

Jon Hartley: So I want to first get into your early life. You were born in New York City in 1943, when World War II was still happening. Your parents were in the medical profession. How did you first get interested in law profession?

Richard Epstein: Well, I mean, they were, but they were entrepreneurs as well. My father was a sole practitioner and it was very common in those days for you to take it basically in a semi-attached house, redo the first floor into offices. And in my case, my father was a radiologist, so we had X ray machines and so forth.

My mother ran the office and I would watch them run upstairs for lunch and then fall downstairs again. And I began to realize very early on that whatever they were doing, i.e. medicine was a business. And they were extremely entrepreneurial in the way in which they did it.

I don't remember the war. I was basically two when it ended. But certainly by the mid to late 40s I was reasonably confident. And by 1950 I was an expert, quote unquote on the Korean War. And I could tell you all the electoral votes in 1952 in the Eisenhower Stevenson campaign.

How did I become interested in law? It was by a combination of observation and a deep recognition of the fact that I was a klutz in the following sense. If you asked me to make anything, build anything, fix anything, I could not do it. So I was not going to make my living with my hand.

I was going to make it with my mouth and my pen. And I knew that very, very early on life and the single biggest problem I had with my parents was persuading them that my father, who was immensely good with his hand, did not have a son who followed in his footsteps.

And I became more and more interested in sort of the natural law tradition. Now what do I mean by that? From a very young age, I used to just sit there and watch things and I would watch everyday things and so, you know, how do lines work? Going in and out of subways, for example, was a very interesting problem for me.

And if I wasn't looking at subways, what about delicatessens and then what about banks and so forth? And so my life began as somebody who sort of observed implicit regularities. And kind of realized that the people who were doing this stuff had no idea of what they were doing and until you stop them and ask them to explain.

And then probably they could. Well, that turns out to be the origin of a natural law theory which you develop as you get somewhat older. The reason they use the word natural law is most of this stuff just happened. And the way in which the great early thinkers, which I was raised in, I'll talk about that in a second and develop this stuff, is by an incredible sense of observation of what had happened.

And then identifying the regularities that the people who participated in these events were often unable to do. So I go through law school, rather through college, and that basic temperament of my mind was very much set there. The single most dominant constraint on my academic career is I do not know how to take notes.

And I mean that quite literally. And so I can't do any kind of archival work because it's utterly useless. I can't take notes in class. And it also was a case in which I like to flip back and forth between areas and then figure out how they were put together.

So in my sophomore year, I go to the dean at the college at Columbia, a man named John Alexander, a great man, I might add. And I said, I don't want to major in anything. I like to concentrate on a bunch of things. Math, I'm not very good at it, but good enough.

Philosophy, a little bit better and I did sociology. And then I always took courses in the physical sciences because largely under the influence of my father, developed them by myself. I became aware of the fact that my general academic strength was an all purpose guy without any distinctive peak and without any real weakness.

And so I was able to move back and forth across different areas more rapidly than anybody else. And so then in the college I did that. And then where do you go to law school? And I made the decision semi-historic. I like to think that I would try to get myself a scholarship to Oxford, but I would not study philosophy, politics and economics because I already had so much of that stuff.

Because in those days at Columbia, in my third year, I took graduate courses in philosophy as I just didn't think I needed. So I said, I go there and Study Roman Law and Medieval English Law and so forth. And by God, the program actually took and I did all the things that I said.

And so I come back to the United States and this is extremely important. I'm a student who's out of sync with the rest of the world. I enter into the Yale Law School, half freshman, half second year student. On the freshman courses, I had half of them in strange ways.

And I could still remember trying to go into the intricacies of various rules on civil procedure. And the teacher didn't want me to talk about that detail tale at all. But that's the way I've been raised at Oxford. And then I took the upper division courses and I, you know, I had many influential teachers.

The one I'll mention most was an economist named Ward Bowman. He was not a lawyer, but he was a guy who always tried to figure out how these institutions were put together. And he often got it wrong. But he was always on the right track. And sometimes he actually got it right.

So I leave the Yale Law School and I have this kind of strange background that I have to interview for a teaching job. And this is where fate intervenes. It turned out it was the seventh game of the Boston Red Sox St. Louis Cardinals worker series and Jim Lomberg was pitching against Bob Gibson.

A friend of mine, now retired from Stanford, Tom Gray, had put his name at the bottom of a list organized by a man named George Lefkoe for teaching at the University of Southern California. And so I put my name down as 11th between his and Tom says, you know, I already have a job at Stanford.

Shows you what the world was like. You could take my interview. And it was the last interview, and it was supposed to be for 20 minutes, and it lasted for two and a half to three hours because we just kept on sparring. And George was one of these guys who sort of liked to show how much smarter he was than all the undergraduates in the law school he was talking about.

And I would have nothing of that. And so we got into a real tussle. And one of the nice things about that interview is when George understood what was going on, then he stopped pretending to be a grandmaster. And he really had kind of cheek by jowl fighting and so forth.

And he invited me out to USC to teach. It was kind of a wild time. And so I tell this story to everybody, and you have to believe me because it's true. So I go out there and I get there for an evening dinner, this very bright little kid, 7 years old, is there.

And I think to myself, he's going to be a law professor someday. And sure enough, he went to the University of Chicago. Editor in chief, and he became dean of law school. His name, Mark Miller. You could figure it out at that age. And why could I figure it out?

Because I was kind of like that kid, too. Precocious and slightly obnoxious, but very respectful of other people. And then I kept on going the next day, on and on. And finally, when it's all over, 14 hours of straight interviews, a man named Martin Levine, who just retired, I think, from USC, takes me to a topless bar.

That was the way in which we did business in those days, rather differently. And so I go back and I get the offer, and I go out with Dorothy Nelson, who's still the dean. She retired, but she's still alive and in pretty good health. And so she says, well, what do you want to teach?

And so I. I didn't understand this question. I said, well, Dorothy, what do you want me to teach? And she said, I'm gonna do you a favor. She says, I'm going to let you teach the heaviest load on the faculty. And thank God she did. So I taught four major courses in the legal writing program my first year.

And you asked about how I came to write takings books like that. Well, the answer is that book was written 17 years into my career. And I started off as an Oxford kid, and I knew a lot of Roman law and a lot of Medieval law and a lot of torts law and so forth.

And as I went through all this stuff, my own sense of systematization took over. And I found a lot of these areas very unruly. And I became allergic to the view that if you don't understand the way things are, that's because nobody can understand the way things are.

You have to sort of muddle through case by case. But I had had been trained in the sciences, in math, and I always thought there was a formal structure on this stuff. And I worked very hard to figure out what it was when I wrote my book Simple Rules for a Complex World.

This was many years later when I kind of figured out what the basic outlines were. And so as I went through the tort, property and contracts law and restitution law and so forth, I taught them all mainly because I wanted to see how they fit together. And what happens is I do all this stuff, and then I look at constitutional law, and I said, you know, there's something deeply wrong here.

There are two sets of books, there's this private world set of books that makes perfectly good sense, and this public set of books, which seems to me to be stirred crazy. So you ask, what was the mission in the most general terms of my takings? Well, it was to say that if you understood how the private world, private law world looked, you could then translate it into a public world.

So you would not have two separate spaces. You would have one comprehensive theory. And then when you try to put the two halves together, a comprehensive theory essentially meant that the public side was quite crazy. And so I sat there, this is in the middle of the Reagan administration, so there was some sympathy trying to explain that you have to start completely over again.

And once you do that, with some fairly innocent premises and moving this way and that way, by the time I got to page 281 of my Takings book, it turned out I discovered that the New Deal was flatly unconstitutional. So what was the reason behind that? Well, the simplest version was there are always collective action problems.

And the correct way to try to think about them is to figure out what everybody's initial stake is before you have the government intervention and then try to expand the pie without shifting resources back and forth so that everybody gets an equal rate of return on whatever investment he has in that system.

The modern view on this stuff was, yes, we put everybody into the pot. And then what we can do is we could take the surplus and move it wherever we want. And by God, if we're really clever about it, we can make sure that some of the initial endowment is transferred to somebody else.

And so what you did is you had these two completely different versions of the public sphere. And my view was that the transfer for society is always going to be unstable because the winners will be avaricious and the losers will be desperate, and they'll constantly fight. Whereas if you stayed in the first world where you get pro rata improvements on your investment, the only way you could get better off is to make somebody else better off.

And so you have an expanding pie, not a shrinking pie. And strangely enough, by having strong property rights and a government that can get rid of this high transaction cost situation, you're much better off than you are in this other state. And this was decided 40 years ago.

I wrote many books in the interim, including or afterwards including The Classical Liberal Constitution. But if you're trying to figure out the sort of the one thing that would be the one that organizes pretty much everything.

Jon Hartley: So I'm going to get to. You've been teaching since the late 60s, since 1968, and a lot of your work has been focused on property contracts, torts law and economics.

You've taught all these classes and many more, and from there you build this conception of constitutional interpretation from that. A lot of this is discussed in your 2014 book, Classical Liberal Constitution. We just talked a little bit about your first big hit in the legal profession, which was on Takings: Power of Eminent Domain, and you published this 1985 book, Takings: Private Property and Power of Eminent Domain.

Richard Epstein: Yeah, but before that, I should mention, I wrote a bunch of articles on tort theory starting in 1973, 74, 75, and 1979, which developed a comprehensive theory of the private law. And so starting on takings, it was a question of figuring out what I had developed, mentioning the method, I told you, a translation, and putting the two things together, which is very much not the style of most constitutional lawyers.

Jon Hartley: And then takings work a lot of this was sort of explaining where takings clause in New Deal jurisprudence went wrong. And then fast forward to 1994, you write this book, Bargaining with the State. You articulate sort of a doctrine of conditions in where you speak a lot about how the government uses monopoly power, received grants, licenses from the government.

Milton Friedman wrote a lot about occupational license during his PhD thesis and his book Capitalism and Freedom, 1962 book, one of his bestsellers. Occupational Licensure has actually grown a lot since these books.

Richard Epstein: Only gotten worse.

Jon Hartley: Only gotten worse, now about 30% of the US workforce is licensed. It's up from like say 5% in the 1950s. I mean, explain your thinking on occupational licensing.

Richard Epstein: Let me explain it. What happened is you have to figure out what's the relationship between the Takings book and the Bargaining with the State book. And what happens is in the takings book, at the beginning, I put a picture of two pies literally on page one.

And the first pie is the inner pie, and it has slices that are reasonably determinate, a point that you could argue. And then there's the second pie, which gets bigger than the first pie. And the key element about the outer ring is it doesn't compromise the inner ring.

So the first set of insights about a taking doctrine is that there's somebody who has X set of entitlements in the initial state of the world. Either he keeps those entitlements or he gets compensation from them for everybody else. So you can't have a situation of Pareto superiority, I'm much better off than you are worse off.

Because those things lead to exactly the kind of political struggles that I mentioned. Well, I finished that, and then I looked again at the outer ring, and I said to myself, why are you saying that this outer ring has to be proportionate to the inner ring? Which is the thing that I had argued beforehand, and I thought a long time about all of this stuff.

And then it turns to me that there's a very simple economic insight that allowed you to know this. So I'm going to ask the reader or the listener to think of a world in which you have the northeast quadrant on the Y axis. You can improve one player by going up, and on the X axis you can prove the other player by going down.

If in fact the only thing you believe in, in Pareto improvement, your first move could be anywhere in that area. So just to take two numbers, there could be either 5 for x and 1 for y, or 5 for y and 1 for x. But how do you decide which of those two things is correct when they're both Pareto improvement?

And the answer is, if you don't have a normative theory, you're just going to fight. And so if you had the optimal cooperation, you may have been able to get six units of gain, but by the time you're done with the swabbling, you're down to two or three.

And so the question is, how do you discipline that outer circle? And then what I did, I drew in line at the 45 degree angle and I said, what happens is, if you're serious about this, the Doctrine of Unconstitutional Conditions said that you always have to be on the diagonal, that X has to be equal to one.

And so if you can do that, the only way X can go up is to make Y go up. And so what happens is it necessarily ensures that there's an even division of the surplus and stops dividing. The next question is, can you generalize? And the answer is you can.

What you do is instead of having a graph, what you do is you now have a multiple thing of a jiggy and you have 22 people in there, a one, a two, a three, a four, and you figure out what it is. And what you do is you insist that there be a non discrimination rule, so that the rate of gain of each of these people from the original position is also constant.

And so the insight about how you stabilize the surplus turns out to be scalable. And if it turns out to be scalable, then it turns out to be stable. So you then have to do is you gotta look around the legal system and say, are you just whistling Dixie or there's some people out there who actually do this.

And it turns out there are a large class of rules both in private law and in public law called non-discrimination rules. And what are those rules about? They're about collective action problems where the non discrimination rule keeps you on that diagonal and so therefore prevents surplus dissipation. And you see this in property, and you see this under the dormant Congress clause.

And so what you come up with is the best of all things develop a theory abstractly seem to think that has the right properties. And then when you look around, you don't find the Rara Avis that never appears. It turns out that the huge numbers of doctrines that are developed which actually comport to that situation.

And it was from that that I developed the unconstitutional conditions doctrine. And so what are the questions that you start to ask is how do you figure out what's a deviation from that doctrine and what's not? So I'll just give you the simplest of examples. One of the questions you always have to ask is, how does the state exercise its monopoly power when you wish to get a driver's license and go on the public roads, right, fair question.

And so I give people two statutes. One statute said, if you wish to get a license, then what you have to do is to register to vote for the Democratic Party. And the other statute says if you wish to drive in this particular state, you have to agree as a condition of getting a license to resolve any particular dispute that arises out of accidents in this state.

In this state. And that's an efficiency condition, because otherwise, if you have somebody in Massachusetts who's from Wyoming and somebody else is from Florida where they supposed to litigate this suit, and so what you do is go through all the conditions that can and cannot be attached and figure out whether or not they have efficiency properties or not.

This gives you the following enormous advantage, which is you can now tie everything up to the antitrust law insofar as it's the body of law which is trying to figure out what particular private actions are disadvantageous in a principled fashion and which are the ones that are justified on efficiency ground.

So what I discovered is when I was a libertarian, I didn't have much use for the antitrust law because it's not force nor fraud. And you remember when you made the introduction, you started to talk about that principle, but it turns out you have to keep that thing in place.

And so that the world is not dichotomous, whether you're talking about the public sector or the private sector. It's a trichotomy. You have to have anti force and fraud rules, you have to have pure competition rules, and then you have to have rules regulating monopoly powers of which the most common are common carriers in public utility.

So at this point, what you do is, you go back and you start to read some of this stuff. And amazingly enough, these guys knowing nothing about anything, okay, what they were able to do is to intuit the rules that you had to put into play. And so there are geniuses like the man named Matthew Hale who figured out that you needed to have some form of rate regulation on what you can charge if there was only one harbor in town to which all boats had to come.

And he developed a very sophisticated theory which essentially, 200 years later, was carried over into the American rate making business by name. And then we had all the great issues that basically came with the rise of the railroads and so forth and telecommunication in the period, roughly speaking, between the end of the Civil War and the beginning of the Second World War.

And when I look back at these principles, I said, who are these bozos? They seem to understand what was going on. And so, even if their rationales were not always the most precise, and they were not always wrong by any means, they were. They seemed to have a very intuitive branch of what was going on.

And so that point you develop a theory of judicial knowledge. And it turns out there are very few judges who are as nutty as I am and constantly go back to first principles in this way. But these are people with an immense amount of experience. And what they do is they have a keen sense of observation, and they put it all together and they develop a system, Tinker with it a little bit.

Make the occasional mistake here, but essentially the great genius of the American law is in the period of industrialization. If you start looking at what legal doctrines start to take place in what space, it turns out most of the stuff is reasonably benevolent and quite good. And so they would make mistake at the edges, but they had the right attitude on rate regulation, right attitude on assumption of risk and various kinds of cases, very strong and skillful rules with respect to intellectual property, including both copyrights and patents and so forth.

A pretty good sense of how it is that federal jurisdiction should apply. And so you come out of the 19th century and you say, my God. Now, let me contrast that with the general view in the legal profession. We have a dirty word in law called Lochner, do you know what Lochner is?

Jon Hartley: No. No, I'm not familiar.

Richard Epstein: Lochner is a case called Lochner against New York. It was decided in May of 1905, and it had to do with the question as to whether or not the state could impose a maximum hour regulation on workers in the bakery industry. And it turned out this case was deeply problematic, and in the court below, the state regulation was upheld 4 to 3.

And it comes up to the Supreme Court. And by five to four, they say that this regulation is not a legitimate health regulation. It turns out they regarded it as an imposition on commerce. So you now put yourself in the position of the New Dealers and so forth, who, for the most part, did not think that there was any logical preference for monopoly by competition over monopoly.

And the denunciations pretty much were everywhere about this case. And it became known as the Lochner era, as if it defined every case that took place between 1870 and 1940. Because what it did is essentially it invalidated safety regulations of some sort or another. And so I start looking at this case.

And there was also a lot of work by David Bernstein, who did a lot of this stuff. And all of a sudden I realized that this, this case was perfectly sensible. They actually knew what they were doing. What they did is they did not like monopoly regulation. What they did is they didn't mind safety regulation.

But if you looked at this particular statute and saw who was covered by it and who was exempted by it, it turns out it was a classic illustration of what economists know to be the case, which is you can have fake health care regulations in an effort to distort the competitive relationship between two rival firms, one of whom is under the regulation and one of whom is not.

And so that led me in part to the Takings book, realize that many of the things that modern constitutional law regarded as abhorrent were essential parts of my system. So then there is this following contradiction. If you looked at the progressives, their attitude would be, my God, we've got all this kind of regulation.

The world must be coming apart at the seams, right? Exploitation everywhere. You then look at the economic position and what's the period of greatest growth by far in American life? 1870 to 1940, same period. So they just got everything wrong about the way in which the system started to work.

And then if you start looking at the justifications that take place in the New Deal, the central proposition the New Deals have is we are completely indifferent as a constitutional matter about the relationship of competition to monopoly. And if what we want to do is to put a monopoly statute in place, God bless us, you're not allowed to stop it.

And so there was a famous case called Nebbia against New York, in which what they did is they decided to have price controls on milk, right, in a perfectly competitive industry demanding minimum prices. Now standard regulation is a monopoly in which you put maximum prices skillfully determined to prevent that kind of extraction, making sure that the firms get enough money so they could recover on their capital.

But. But this was a case in which they put minimum prices at the request of the farmers to essentially ensure that they could organize a cartel. And it was upheld in these things. And so that's the kind of model you have. And in the post war period, there's this constant struggle.

Are we trying to protect monopolies? Are we trying to undermine them? And what happened when I started writing in the Reagan years, for the first time, there was a reasonably coherent group of individuals, of which I was one, who said the distinction between competition and monopoly is well worth making.

And the Takings book was meant to make sure that monopoly type regulations that the state gave to its favorite person could no longer survive. We were called to be ruthless individuals, but this was, I thought, the most social program possible. And so you put the whole scheme together, we're kind of moving that way.

Did Milton Friedman and so forth and George Stigler understand it? Want the real answer? Not really, because they had a very different way of looking at the world. And not a bad way because it was immensely important at the time. All of these guys basically grew up in the 30s and the early 40s, right?

They're born 1912, Stigler 1911, Coase 1910. And what they do is they come up in a world where New Deal cartels are riding on and their first instinct is to be anti-cartel guys. And it turns out in these industries there aren't any real particular reasons why it is that you need any form of rate regulation at all because they're competitive industry.

And so their great contribution was to say, strike this thing down, get rid of this one and so forth. Market liberalization was what they were behind. Then you start getting to other kind of industries where it's not so clear that you could have a competitive market. It's a network industry and so forth.

Or you have the, the great problem, the marginal cost problem with respect to the bridge. You remember that one, Jon? You know, you have, you have to build a bridge over a river. And you can do it one of two ways. What you can do is you can say, okay, we'll let the guy charge whatever he wants.

And it turns out that if he does that, he gets a monopoly, right? Or you say we can regulate him, at which point you run the risk of confiscation. And so you know what they did in the actual contracts in the 1880s, incredibly clever, they said, we're going to give you a period where you can get prices above the variable cost until you pay off the underlying front end cost, after which you can only charge for the variable cost since you paid for the equipment.

It was a two tiered system and it was written about by both Vickrey in the United States and Ronald Coase in England, if you recall. Right. Now, what they did is they kind of devised the same problem. Because what they saw is if you don't have a competitive solution, what you have to do is to figure out which kind of inconvenience you can live with and which kind of inconvenience you have to bear.

And so instead of developing a model of ideal behavior which we all love to have. All of a sudden you're in a very different kind of world saying which of the two risks that we are facing in this particular case is the greater? And how do we figure out institutional arrangements that were counteracted?

And so what happens is, if you could get a competitive market, really want to keep it, but if you can't get it, then you enter into this terrible space where you're trying to figure out what kind of regulation is better than what other kind of regulation, knowing that no matter what you do, you can't quite get it perfect.

And so the thing that you have to learn as a lawyer is when there are competitive situations that are ideal, don't mess with Mother Nature. But if there aren't, then the question is how you rig a system to figure out the way in which you put, for example, the fixed cost with respect to a bridge.

And this becomes the same problem that you face with patent law. So friend of mine named John Duffy wrote a nice piece applying the marginal cost controversy to patents and wrote it 15 years ago. And what you can see that was that the doctrines that apply to 19th century problems also carry over to 20th century problems, and you have to be able to kind of deal with it.

And so I never got myself involved with intellectual property as a serious matter until I was hired by somebody who said, we have this serious problem on an inducement to breach of contract claim, which is something I worried about. Inducement to breach of contract is something that, you know, under the name of tampering.

So the most famous case was there was that famous opera singer named Ms. Wagner, and she was under contract to perform for one movie theater or opera's house. And somebody else stole her contract away and said, you have to work for me for a higher price. And the question is, what remedies did the person who made the original appointment have to stop her?

And it turned out it's not an easy question to figure out what goes on. But they allowed the injunction to take place. They wouldn't allow the woman to be forced to sing for the first part. Ms. Wagner was from Germany. She could have gone back to work for the first company, but the ground was so spoiled that what she did is she went back home to Germany.

And the lesson, of course, was very clear. There was certainly a lot of gains to be had by having her sing in England. She was a great singer. And somehow or other, after they balls everything up, all that stuff gets lost. And so one of the things that you then do as a business lawyer is you say if I have something that looks like it's heading down the road, how do you figure out a way to prevent the abuse?

By one party, on the other hand, without killing off the deal on the other hand, because both of these are completely undesirable outcome. Now this, of course, then explains something else about why I'm a kind of a strange constitutional lawyer, right? Very few constitutional lawyers actually are business lawyers, and I've always been a business lawyer from the first day.

And understanding how these business arrangements work then gives you a sense as to what kind of regulations that you put on top of them are likely to make sense and what kind of regulations are not going to make sense. And so you tailor your situations there. And so this pattern that I had in college was know a lot about everything, but huge amounts about nothing.

It turns out to be the right strategy as far as I'm concerned, because you get a range out of academic stuff that you can't get if you deeply specialize in one particular area.

Jon Hartley: On say monopoly. I think that's a great summary. I mean, it's amazing to see how powerful the administrative state has become at the federal level, the congress, the power there.

We'll talk a little bit more about that in a bit. Occupational licensing at the state level, rapidly, not only do we license doctors, but we also now license dog walkers, nail technicians and braiders and so forth. I want to sort of get more into constitutional interpretation because I think that this is really where the focus of a lot of your career has been in the past few decades.

And so, in 2006, you wrote How Progressives Rewrote the Constitution. 2011, you wrote Design for Liberty: Private Property, Public Administration, and the Rule of Law. I'm just curious, how might your thinking, you're thinking, you know, you say you're in the natural law tradition. How might it differ from originalists, let's say, Bork and Scalia, who you were on, Chicago Law faculty with at various points, and they were legal positivists.

It's textualists, they help meaning of the text. Is it fair to say that they're, you know, maybe similarly unhappy with the progressive legal movement during the 20th century, you know, having, you know, maybe calling that sort of living Constitution, you know, being promoted during the Warren and Burger courts.

And we also have, I'd say, other sort of ideas, jurisprudence, say Adrian Vermeule's Common Good Constitutionalism, which is also very different. I'm curious, you know, what is your synthesis of constitutional interpretation that's embedded in your 2014 book, The Classical Liberal Constitution.

Richard Epstein: Okay, well, I mean, where do we start to go back to Roman law?

And it turns out that the rules of interpretation that Scalia and Bork tend to believe in bear no relationship to the historical rules of interpretation done by large numbers of people, none of whom you would call Progressives or Marxists or anything of the sort. They were people who, I think, were much more sensitive to the way in which language worked and developed a whole series of protocols to understanding what went on.

And so before I did the book on the constitutional law, I spent my time interpreting the Lex Aquilia”. And that's a statute, which I'm sure is on the tip of your lips, but it roughly said, in effect, anybody who kills a kidder unlawfully, a slave, or a herd animal shall be liable and damaged by some rather arcane formula.

And so you look at this statute, and then you say, well, how do they explicate it? And it turns out that they spent 30 or 40 pages figuring out what it means to kill things and what it means for these things to be unlawful. And they didn't quite get it 100% right.

But essentially what it did is it tied in with a very powerful theory of how you organize a case, which was also captured in the Roman pleading laws, which that are develop rules that develop at the same time. So essentially, the way to understand language is what it is is it's a game of successive approximation between the descriptive and the normative.

And the question is, how do you make these steps and why? And the first thing that everybody notes about a particular language is you can't say everything at once. You can't say everything first. What you have to do when you're thinking about language is to start with the notion that what you're trying to do is to find a way to get clear the message so that you don't get overwhelmed by the noise that's surrounding it.

And so the pleaders essentially started in the following way. What I have to do is to explain to you why it is prima facie as a first look, you should be liable to pay damages to me. And it has to be a clear enough reason that everybody can understand it.

And it has to be operative so that other people can apply the rules that are applicable to it in a way that doesn't lead to hopeless squabbles and division. And it turns out the way in which everybody starts this is with a phrase which says, you can't hit anybody else.

Now, what does that mean? And then you realize it's a funny word. You could hit somebody in the sense by giving them a love tap or you could hit somebody and try to maim them. And what's quite clear is you're not trying to rule out beneficial conduct. And so what you're trying to do is to figure out that situation which by either a physical or a chemical change, results in the position of the party who's been hit having been essentially made worse off.

And so what do you do? You have to worry about describing it, then you have to worry about evasions. So you have to have a clear principle and then recognize that somebody who's going to be tagged for a large liability will do an enormous amount of singing and dancing in order to escape it.

And you have to be able to prepare countermeasures, right? So it's a kind of a game. And so I will give you the illustration that does this, involving my 5 year old nephew at the time, and he was acting up like a 5 year old and I said to no, stop hitting me.

So what do you think he did? He kicked me.

Jon Hartley: Maybe.

Richard Epstein: Now what, what was he thinking? He said, well, you said I can't hit you. Everybody knows that the word hit involves the hand. So you didn't tell me I couldn't kick you. And then somebody says, as an outsider, is that what you really meant in terms of the social situation?

What you say is Noah's evasion of the hit norm resulted in the same amount of harm. And it turns out you said, don't hit me with your hand. So I take a stick and I start hitting you with the same thing. So we have what we call the need for a description of what's wrong.

And what's wrong turns out to be, to use the phrase that they eventually hit upon the application of force by one person against the body of another. And the Romans called that “corpore corpori” by the body to the body. Right. And the reason they do that rather than the other phrase is because of the anti circumvention norm.

And they wanna make sure that all applications are force of court so that you can't play these kinds of games. And so you start to see that and it develops in the Roman law. And then you go, you look at the English law many hundreds of years later and you know what happens?

They do exactly the same thing. Now why are they doing this thing? There may have been some cross influence between them, but even if there is, you have to say, why is it that an Englishman would accept a set of rules developed by a bunch of Romans 1200 years before, when their cultures are many ways are completely different?

Well, it turns out. There is an answer, and that's the natural law answer. You can think of a state of the world in which presumptively, it's better for one people to use force hostilely against somebody else. And so if you figure out in Rome, you're going to figure out the same thing in England.

And the reason there would be a reception, which it sometimes is, is because the same conditions apply. And this is true whether you hit me with a gun or whether you hit me with a sword or a howitzer or a laser beam, right? And so it turns out that the principle is pretty universal, as is the question about controlling these evasions so that you use that term.

But people are much more clever. So the second thing that comes up and then I'll figure out is, okay, I won't hit you. What I'll do is I'll set a dish of poison in front of you and tell you that it's helpful. That's not the application of force.

So in every system, what develops is what they call an action under the special circumstances, where in effect, if you give something somebody and they consume it under mistake or under coercion, you treat it just as if you had done the other thing. And it turns out that's developed everywhere.

So now you look at constitutional law. What does this have to do with constitutional law? What you do is you get the state right and it says that it's not allowed to take anything from. So what it doesn't do is it doesn't take it, it just simply blows it up.

And the question is, can you recover under the constitutional norm for that? And you could see immediately how it is that you're going to need the same anti-circumvention norm there to prevent essentially the willful aggrandizement of one person's property at the expense of another. And so you go through all these cases and what you discover is exactly the same technique of interpretation is given to the use of force in public law that is given in private law.

Because what's common about these situations are the sort of invariant physical conditions against all which this stuff takes place. They're the same in every language. So what happens is, if you understand the physical stuff, you sort of understand where the universality comes from. Well, that's part of it, but then you got other things you have to worry about.

So somebody says, well, yes, I hit you. And then he turns around and he said, you know, but I did it in self defense. Well, you assumed the risk. And so all of a sudden what you're saying is, yes, your prima facie case is right, but there are reasons why it is that you should not be able to make good because it turns out that you were really the aggressor, right?

You were not the aggressor, self defense is why I hit you. And so the plaintiff was saying you were an aggressor, but you weren't, you were responding to his threat. And what you slowly do is build out the system. And it turns out the same invariant rules apply whether you're building it out in modern England, Ancient Africa, Roman society.

Because the physical and chemical constants are what drives a particular analysis. And so when you do comparative law, what you almost always discover is that all the differences that you find are on second order question. I mean, so to give you what's the second order question you ask, right.

Well, suppose somebody's taking your property and it's the person who gave it to you. What kind of remedies do you have against them? Well, the Roman remedy said that you could never get a declaration against the party who was about to take your property. You had to wait until it was taken and then bring an action for being evicted.

The American law allows a declaration that you can't do it. Well, what's the difference between the two of them? Not all that much. Right, but there is a difference. And why the difference? Well, the Romans were very much more constrained on the resource side, right? You can imagine.

And so what they did is they waited to the last possible moment they had before they applied the remedy. Whereas in America and England, you have more prophylactic abilities to do so, so that you're willing to intervene a little bit sooner. Now, how much of a difference does this make?

Well, in certain situations it could be very important, but in most cases, let me ask you the question. How many times in your life have you felt uncertain about the possession of your property vis a vis somebody else, that you felt necessary to consult the lawyer as to whether or not you were entitled to some kind of protection?

And they answered that question. What are you talking about, guy? Right, so the reason that these things don't matter and do matter is in the large society, if you look at the kinds of cases, the great achievement of the legal system is not that it solves disputes after they occur.

It's that what it does is it guides people's conduct so they don't engage in stealing other people's property. So you don't have to figure out what the remedies are when they start to do and then which cases get to the lawyers? Well, it's not the cases where everything goes right, it's the cases where everything goes wrong.

And at that particular point, it was a very rarefied subset. And now all of a sudden, all these remedial complications make a great deal of importance to the way in which particular cases should come out. So that when I started teaching law, my view was always to look at a particular dispute and figure out who was right and wrong and what remedy applied and why.

And you could get a lot of divergence of opinion. And it's very important to be able to do that because that's what litigators do to this very day. But as I became a little bit older and maybe wiser less so, what happens, I realized that the great importance of these various rules was not in the way that they necessarily solved disputes that took place, but the way in which they limited the number of disputes that occur.

And so when you start then looking at all constitutional law, it's the same method, First Amendment freedom of speech. Well, there are a lot of cases where you're asking whether or not somebody is engaged in freedom of speech. If what he does is he yells fire in a crowded theater, takes out a rifle and says, I'm gonna shoot you unless you capitulate, and so forth.

And so now what you do is you have a rule that says freedom of speech is protected, but the threat of force is not right. Well, you then have to figure out, well, how do you know which it is? And so the famous case from private law was somebody who said to somebody else, if this were not a size time, I would run my sword through you.

And so the first thing you ask is, what's the size time, right? Well, size time is the judges are in town and what the guy is saying, I would kill you except for the fact that they hear. Now the issue you then have to ask, is he faking or is he telling the truth?

He's saying that because he's going to kill you and he wants you to put your guard down or not. Well, that's a fact intensive dispute. Fast forward 2000 years or whatever it is. And now you have somebody who's in an assembly and what they're trying to do is to encourage people to rebel against the state.

And so what are they doing? Is it a bunch of people reading a Marxist tract about the necessity for class warfare, or is it a bunch of guys who's sitting there trying to tell you how it is that you put together a bomb and plant it on somebody.

Right. And so it's the same question. This is anticipatory conduct. Can the First Amendment catch it? And here there's no immediate threat. But as the famous judge said, the threat may not be immediate, but if you wait until it is immediate, it's too late. And so, this was a problem of international law.

What are the intermediate cases? Well, you look at (Hugo) Grotius, the great 16th, 17th century writer, and he posits one case to which we yet to have an answer. He says, what you do is you have an enemy, and what they do is they amass on your border, but they don't attack.

The question is, can you have a preliminary attack or response against them, or do you have to wait until the attack is imminent? When was the last time that problem came up. In Iraq, Iran, right? What happens is the Israelis are sitting there. Do you have to wait until the bomb is in the air?

Can you take them out preemptively? And it turns out it's a very delicate calculus as to what you do and all of these things. The strategy is you're always making approximations, you're always doing the public and the private law comparison. And essentially what you do, I think in the last of these cases is waiting is utterly futile.

What's the seriousness of the intention? Well, the first thing you do when you're doing this stuff, if somebody says he really hates you and he wants to kill you and he's going to do everything he possibly can to achieve that, you believe it, you know, and you know, that's the rule.

So whenever you go through a security line, remember they always tell you we take all jokes seriously. Right. So don't talk about carrying a wet penny because we're going to respond. And so we basically wean ourselves from the immediacy rule, which is a very safe rule in the sense of preventing undue aggregations of force, but it's a very dangerous rule because it could let the amassing take place until it's too late.

And if you recall, the Israelis have faced this before. They faced it in 1967, right, when the Egyptians blockaded. First question, is a blockade an act of war? The answer is yes. Does it involve the use of force? The answer is yes, but you haven't shot anybody. But it's a threat of force made credible by the weapon you have.

And the Israelis basically attacked. And then the question is, you look at the United Nations Charter and it says anticipatory, the self defense is not allowed. So what do you think happens to the charter? It gets junked because it's too restrictive a condition nobody's going to abide by.

Jon Hartley: I guess one question I just have is like in terms of a lot of this, you know, I guess taking a property centric kind of lens of constitutional interpretation, like, you know, how do you determine, you know, what is property and what are limitations, I guess in terms of--

Richard Epstein: ---what is property?

Jon Hartley: Well, you can see these issues like for example, servitude? I mean, these were huge issues that were sort of left somewhat open at the founding of the country (namely slavery) and there was a civil war fought over it. Even now there's some questions of can you indenture yourself? Can you sell shares in your yourself for, say, student loans, income share agreements? This is something Milton Friedman wrote about.

Richard Epstein: Well, I mean, it's a very interesting question. I will tell you what the historical argument was. There is a huge debate into the literature as to whether or not self ownership is a coherent concept, right?

I own my arms, but there's no doubt that anybody has that you can own the ring on your finger. And so the question is how you defend the person if you're not quite sure of this. And in the end, what people do is they fudge it. They treat it as though it's a property protection.

But in effect, they then use the word autonomy to describe what it is that you have. And it then becomes exactly the gate presumptively. The argument has always been you do anything as a purpose of agent, then you've done it for your own advantage. So if we start the Pareto ball rolling, we have somebody who's better off and by definition nobody else who's worse off.

And so the argument in favor of freedom is that condition is desirable. But remember I started to talk about defenses, self defense and so forth. Suppose now the thing that you want to do is to take a saber and put it through somebody's heart. At this particular point, the defense becomes credible because the gains to the other side are so enormous that what we do is we allow it to stop.

The central classical liberal thing is suppose the guy doesn't want to beat your brains out, but you're selling mushrooms on a corner stand and he decides to go to another corner of the street and sell mushrooms of a higher quality for a lower price. What happens? He said, I'm really being hurt.

And you're saying this is just an exercise of my liberty. And why is it that you're right and the other guy is wrong? Because you can figure out these disputes simply looking by the two parties to the disagreement. There are customers out there, and in the case where you kneecap somebody to prevent them from selling to the customers, it's not just a rival who's worse off, it's all the customers who can't get the business right.

But if what you do is to cause the same amount of economic dislocation by offering a better price product at a lower price at that particular point, the consumer welfare flips over 100%. And so what we develop in a very principled way is the classical liberal distinction between force and on the one hand, and competition on the other, where one is allowed and one is not.

And then we developed three separate phrases and three different ways to explain this. The Romans understood this, sort of, and they called this. And what the hell does that mean, right? Well, damn means harm, ab square means without legal injury. And what they're saying, in effect, these are the kinds of harms that you're absolutely privileged to complain.

And you then ask, is there a complete theorization of this in the Roman leadership? Answer no. You then ask the second question, do they make any fundamental mistakes with respect to the court case? The answer is no again. And so what it is, their rough intuitive empiricism steers them away from problem.

Now when you come to the economists and so forth, they start talking about externalities, right? And what kind of externalities are these? Are these legitimate externalities? Are they illegitimate externalities? And what they want to say is, they may be just pecuniary externalities. You've heard that term, right?

Jon Hartley: Hmm

Richard Epstein: It's one of the more useless terms in the English language because it doesn't distinguish between two conditions, between competitive losses and losses to a monopolist who essentially has some ability to exclude you from a particular market.

And then the lawyers, they have a third term for that. They talk about actionable injury as opposed to non actionable injury. But the only way you can solve the problem is to go from the two parties who are conflicting and take into account general equilibrium analysis about the way in which their dispute affects everybody else.

And so the force case has negative externalities to third parties, but the competition cases, positive externalities to third party. They're going to be some funny cases in between, as you always know, like trade, slander and so forth. But the point is, if you understand the economics correctly, merge it with law, all of a sudden a lot of the classical liberal distinctions come up as being completely legitimate, coming out of what I think are fairly spare spartan set of initial premises.

And so you ask what my constitutional regime has been for these last 40 or 45 years is to take these kinds of missions, go to area after area that I can find in public and private law, and show to the extent that it's possible that you could actually make the system stand.

Now that means that you have to really learn stuff about all these fields. And so that's why I've always made it a promise to teach things at least once or to consult on the problem. Because what happens is you as an outsider may have a better theory about everything, but the guy on the inside has done this for 40 years.

And so the secret of being an outside analyst is you don't tell them what to do. You listen to people talk, tell them about their field, and you sit back and you do something which I find very difficult in principle, which is to be a passive. To speak person, right?

Tell me more about your business. And once you learn about the business, then I'm saying, well, this is why you did this. And so what the great question is, is a practical matter for the antitrust laws, for example, and so forth, was this an efficiency justification or was this a restrictive practice?

And lots of times when people tell you something, they actually think it's a restrictive practice, but it turns out to have an efficiency justification. They just didn't quite understand it. So your job is to explain their businesses to them after they explain their businesses to you.

Jon Hartley: Just to stop you there. I'm curious what you think about the Coase theorem. Ronald Coase kind of said that, you know, if you assign property rights to people, even if it's not fair, it'll lead to an efficient outcome. And so, you know, even if you, for example, had some sort of cap and trade system where you gave all the rights to one company, for example, they could still trade them away, you know, and even though that may seem very unfair or maybe expropriative at some level, that they'll still be able to trade these rights away to others, leading to an efficient outcome.

And so there's. Okay, a lot of people point to the Clean Air Act and asset RA program during the 90s as being sort of successful example of this limiting sulfur dioxide emissions. And maybe spectrum options are sort of similar in that regard, I'm sure. What you think about Coase?

Richard Epstein: Well, first of all, Ronald and I were very close friends to the end of his life. And it's because he actually, he disliked intensely blackboard economics, as he called it, which meant that he became a kind of institutionalist. But Ronald did not understand his own theory and how powerful it was.

So it was kind of one of the ironies. The last time I had a meal with Ronald, he was about a hundred, and he sat down and he announced that “my life has been a failure”. To which I said, “Ronald first, anybody whose name becomes an adjective is not a failure. So it's you, it's Marx, it's Freud. No, Einstein. Okay, Ronald, stop. But I said, now let me tell you why you're wrong”. And he didn't quite get it. Ronald basically looked at a series of very sophisticated late 19th century English nuisance cases in which you had variations from the simple problem of one person, many huge amounts of pollution, to the land of another.

So one of his cases was, you emit some pollution, it hits a wall, and it bounced back and gets you into your own attic. The question is the guy who building the law responsible for the nuisance or not? And things like that. I told Ronald, I said, no, that's not what this is about.

That is one illustration of a larger problem where you have large numbers of people with different inputs and so forth and they're voluntary transaction barriers to voluntary transaction or cost and trying to figure out how to organize voluntary transaction. So what you have said is first you may have an ideal theory of what you want to do, but then measurement problems and similar issues arrive and your first best solution cannot be done.

So give you best a very simple kind of situation. You want to charge somebody for your services and the ideal way is to try to figure out what the marginal contribution that you have made by when you supply him, right? And then you start looking about this in terms of landlord tenant relationships and how many people run leases where that's what the landlord gets marginal contribution, nobody.

So what do you do? You take a percentage of sale. Why do you do that? Because that number you can compute by looking at the books. You figure out what a good guess is, whether it should be 2% or 5%. The other stuff is gonna completely break down.

So what you do is you give up on ideal theory in order to get something that's a bit more workable. And it requires people a lot of skill to know these industries and the norms and the ratios to get them right. Ronald did not think of the world that way, so he could never accept the generalization of his theory.

And what I told him, I said, Ronald, you may not know it, but I'm going to ask you one question. Why is there no second Coase theory now? 60, well, at this point, it was 50 years after he'd done the first thing, I said, the reason there is no second theory, Ronald, is you don't need one.

If you actually understand what you're talking about. You have this zero transactions cost world in your mind where everything instantaneously goes everywhere else. Then what you do is in this world, you sit down and figure out what's going to happen to people. And slowly you develop a series of rules and practices, all which are designed to do the following thing.

Minimize the total level of transactions cost in order to maximize the total amount of gain. And I said, if you do that, what you are doing, you can make this operational and you don't have to know everybody's value functions, right? If you want to be a Keynesian, you have to do everything under the sun.

And the aggregates, your method is much more efficient than his, which is why people always talk about your work instead of his work when it comes out to doing things on a level. And that is in fact. Right. So the Coase theorem essentially uses a mnemonic device, the zero transaction cost world.

But what you then do is try to get into the stuff in the transaction cost world. And Ronald was well aware enough about all of this that he would start to figure out what odd anomalous rules seem to be put into place which had this effect of essentially reducing transactions cost relative to gain.

Right, and that's a social welfare theorem, which is operational as opposed to this other stuff. So I've never been a Keynesian because I don't know what you do with these aggregates, particularly since the people in the aggregates are always acting individually. So take a simple thing. If you were to give people, everybody $100,000, say $1,000 like George Bush did, you don't have any idea what each individual is going to do.

Someone's gonna pay off past debt, somebody's gonna build the fund for his child to go to college, right? Somebody's going to go to a fancy restaurant. It just all varies out. So don't try-

Jon Hartley: People save it?

Richard Epstein: They'll save it in different-

Jon Hartley: Like ideas, people are supposed to be spending it, right.

And there's this virtual.

Richard Epstein: But that's all crazy, of course. There's no way you can figure out what people will do. And in fact you don't want to. The whole point is if I'm better off investing my money and somebody else is better off at confusing it, we don't want to force the two of us to take the identical ratios when it's going to benefit us, neither of us.

So you just, you want to make sure that all those decisions are disaggregated and he insist upon aggregating them. And this is not a small error, this is a catastrophic blunder. And you don't have to be a sophisticated economist to start realizing that talking about aggregates is a very dangerous situation because what was the phrase you used at the beginning of this talk?

Methodological individualism. Right.

Jon Hartley: And just to close up there, I'm just curious, you're, you're a self described libertarian, you're a big believer. Methodological individualism. This is no secret. I'm curious, what kind of libertarian are you? Are you Richard and, and this, are you a fan of the non-aggression principle?

Richard Epstein: There's nothing wrong with the non aggression principle.

Jon Hartley: I'm just curious. What are. What would there in your mind, what would the limits on such a principle be.

Richard Epstein: Let me. Let me just.

Jon Hartley: cartelization, theft, and are you an anarcho-libertarian?

Richard Epstein: I'm not. I'm a classical liberal.

Jon Hartley: What is the role of the state in your mind?

Richard Epstein: Let me sort of put it, the problem about being an anarcho-libertarian is you don't have a state. The bad guys will form one on their own terms. So it's a kind of a preemptive situation. And the basic difference between a classical liberal and an anarcho libertarian is a classical litmus has the following general proposition.

You may be very careful about it, impose various kinds of limitations and taxes on individuals, so long as when you look at the pie in the aggregate, the individual who's so burdened is on average left better off than before. And so the argument, for example, about a flat tax with respect to general revenues and so forth and expenditures and is we can't think of any device which will fund the need for collective goods that has less disruptive effect than that.

And so that would mean tariffs are out as a revenue source. Right, because they're differential in terms of the way they go. The base is too small, the rates are too hot. So crazy. And so I've always been that. And so I wrote a book, you know, several articles about nobody could beat a flat tax.

And then you have special taxes for special benefits and special harm. And so you're not somebody who's an anarcho-libertarian. Non-aggression is certainly something that's in the principle. But Murray Rothbard is sort of is the only thing that you were worried about. So cartelization in his world is just fine, right?

And you don't believe that. So what happens is the way I treat it is, you ask me, what's the first move you made out of a state of nature. It would be essentially the control of force. But is that the only move you made? No. If it turns out we could then have another set of rules that allow us to have infrastructure, another set of rules that control monopoly abuse and so forth.

You may continue to make additional adjustments to the basic system that you now have at stage one or two, so long as the Pareto gain position holds. Now what happens? It's a system of diminishing marginal utility. The first moves are really going to be huge. Right? But by the time you get further down the road, you're not quite sure which way it's going to go.

And that's where you want lawyers. Our job is to decide cases that are inconsequential at the margin, so long as they don't mess up the core cases which allow us to organize civilization in the way we want. So basically I'm a tinker at the edges, but my most important contributions are telling people how you organize a world in which my services are not needed.

Jon Hartley: Richard, I really want to thank you for coming on. This has been a great-

Richard Epstein: My pleasure.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast with the Hoover Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Tom, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy. I'm Jon Hartley, your host today. My guest is Thomas Hoenig, who is a PhD economist, a Distinguished Senior Fellow at the Mercatus Center, and the former Vice Chair of the FDIC during the 2010s and the President of the Kansas City Fed for about 20 years from 1991 to 2011. Welcome, Tom. So great to have you here.

Thomas Hoenig: Well, thank you. It's good to be with you and I look forward to our conversation.

Jon Hartley: Start by getting to your early life. You were born in Iowa. You did your undergrad at Benedictine in Kansas. You did your PhD at Iowa State. There's a close connection between Iowa State and Chicago that I think some people might not be aware of. Theodore Schultz and D. Gale Johnson, agricultural economists who were both at Iowa State affiliated and went to Chicago. Schultz won the Nobel Prize. I'm just curious, how did you first get into economics and financial regulation growing up in the Midwest?

Thomas Hoenig: Well, first of all, my dad had a small business, so I had trips to the bank with him. I knew that they were around, put it that way. But actually I got most interested when I was in college.

I took a course, an elective course in economics in my freshman year and just thoroughly enjoyed it. It was microeconomics, but it was very, I thought, useful and challenging. And so I decided that was what I was going to do. Although I did morph into money and banking as I graduated and then got into graduate school.

So I spent a lot of time in economics thinking about economics. And when I left the when I graduated out of my graduate program, I went to the Federal Reserve Bank of Kansas City. And I had my specialty was money and banking. And so when I went to the Kansas City Fed, they had during the period where there were a lot of mergers among banks going on.

And so I went into the banking supervision and structure division of that bank rather than the monetary research division. And in that I learned a great deal because wasn't too long after I joined that we had the Asset Boom of the 70s and then the Paul Volcker era.

And I was in supervision and literally watched with disappointment, I guess I'll use that term in the hundreds of bank failures that were going on just in our region and across the country. And that got me interested even more in what the causes were monetary policy factors in that, trying to deal with inflation.

And so I was pretty well prepared when they asked me to step into the role of president of the bank and join the FOMC, the Federal Open Market Committee, and its policy role. And so I had both kind of banking knowledge and the monetary knowledge. And I found that combination very helpful to me in my career.

Jon Hartley: Well, it's terrific. You were there during the global financial crisis. You were the president of Kansas City Fed when that happened, when those events transpired. And I feel like the financial crisis was both a defining moment for financial regulation and for monetary policy. It was really then when quantitative easing was starting.

I'm curious what went wrong in the financial crisis as you sort of see it in terms of underlying causes. What went wrong with the banks in your mind? Housing central to that was government subsidies important. There was lack of say bank capital an issue. Was complexity of the financial system an issue?

I'm curious. You gave a speech in 2009, you gave a speech titled “‘Too Big’ Has Failed” which was pretty critical I think of the approach taken until that time. How do you define the events of the financial crisis and its causes?

Thomas Hoenig: Well, I will tell you, first of all, I think most financial crisis post World War II, let's leave it. And I'll also kind of mark out Covid but most financial crisis are actually policy related, usually excessive monetary policy. And that's one thing I learned as I dealt with banks and doing the crisis and that. And for example in the 70s what happened was the Fed not wanting to have a slowdown in the economy, repeatedly lowered rates. And then as inflation picked up, they lowered them again, but they never really got an equilibrium. And over that time inflation, as you well know, went from modest 2.5% to 14% by the 1979 period. And what happened is that it baits the banks, in other words, low interest rates, asset prices.

They began to lend more on collateral value and the expectation that the value would only increase because of inflation and they're willing to make higher loan to value loans, take on more risk. And so then when you raise interest rate and those values plummeted, these banks were ill prepared to deal with it and they didn't have enough capital given the size of the adjustment that had to take place.

So that happened in the 80s, 70s, and 80s, and then we actually repeated it in the beginning of the decade of 2000, where I was a member of the FOMC then. I did object, but not enough. And we saw interest rates decline to as low as 1% even when the economy was growing in 2003.

And what that did is it brought forward the speculative elements in the economy because of very low interest rates. You could borrow a lot of money at, say, 2%, buy a company, finance it with debt, strip out the equity, take the cash, move on, but creating increasing amounts of instability until finally inflation took off.

They raised rates. And we had an enormous financial crisis around housing because people have been taking equity out of their homes and spending it. More leverage, more downside risk. And when it finally hit, we had a major problem. Again, following Covid, the Federal Reserve, extended its loose monetary policy, accommodated monetary policy well past the COVID crisis.

It held onto that $120 billion a month injection of new reserves into the system for over 18 months. And we had a breakout of inflation. It exceeded 9% at one point. And then they had to raise interest rates. And, of course, asset values in the banks plummeted. We had the Silicon Valley Bank failure and then a bank run on many banks, because no one knew for sure how they were affected.

So those are the sorts of things you have to think about in monetary policy. What is your policy gonna do to the institutions when you adjust it? And I think that was lost in each of those occasions, and why we had a worse crisis as a result. When I talk about too big to fail, the other side of that was some banks were, shall we say, protected, while other banks were not.

And it created an instability and uncertainty in the system that I think was very harmful to the economy. You know, prior to the Great Financial Recession, when Solomon failed, it failed. We didn't bail it out, and we didn't bail out the banks lending to it. But when we got to the Great Financial Crisis and banks were under pressure, especially the large banks, Citibank, you name it, the, the Fed said, no, no, we can't have that.

So they actually provided enormous amounts of liquidity into the system that the treasury helped provide capital, something they wouldn't do for a regional bank or smaller bank. And so we, we set up an expectation that the largest banks would be bailed out at whatever cost. And that discriminated against all the other banks and made our bank and our economic system less efficient.

And so I had real objections to that as well, Jon, and still do to this day.

Jon Hartley: Well, I guess there's this famous question about should Paulson and Bernanke have saved Lehman? And I guess there's this question of what does a run on, I guess the shadow banking system look like?

And this is a traditional run where I guess you have depositors lined up at a commercial bank trying to get deposits out, but really you have investors, money market funds getting tons of redemptions, people are worried that there's exposure to Lehman commercial paper and that that triggers this, all these redemptions which sort of forces further selling and so forth.

I guess the argument, I mean, it seems like, during that period, I mean, there were a series of these distressed firms, whether it's Bear Stearns eventually getting bought up by JP Morgan or Merrill Lynch getting bought up by Bank of America and so forth. You have some assistance from the Fed in some of these cases, but there are some people that argued that Bernanke and Paulson should have acted more to save Lehman.

And there was a deal lined up with Barclays, I think, to buy Lehman, but I think the UK prevent it from happening. It's kind of the Paulson story that he tells, that that was, I guess, a central challenge. But other I think Randy Quarles, for example, might say countrywide was kind of, I guess the moment that things were getting really bad.

I'm curious what your sort of diagnoses are of, of that period of time and all these bailouts and, and what should have been done differently, if anything.

Thomas Hoenig: Well, my complaint was to begin with, when they decided for whatever reason to bail out Bear Stearns. It was not the largest institution in the world, but they were afraid of contagion effects or whatever the reason was.

I thought that set the expectation. And when you, once you set the expectation, then you live with it. And the expectation was, anything that large or larger is going to be bailed out. It even set the expectations for Lehman itself. Had they let that fail, it would have required, it would have caused, I should say, a whole different, I think, set of responses in the banking industry and in the investment banking industry.

And it would have said, wait, I better be thinking about how much capital I have. I better be thinking about the distribution of my assets on my balance sheet and the quality of my assets and whether I should build liquidity. This was in March of 2008, and then you had, basically, the GSEs.

And you put them into conservatorship, but in fact you bailed out the creditors. Not that, not the investors, but the creditors big time. And so you set the expectation. So then when you give them the Lehman Brothers, you've set the expectations. To change direction at that time is to invite a crisis.

Because now you're saying, wait a minute, those were the expectations, but they, but they're not living up to them. I better run and I better not take any chances because I don't know how other banks like Citi or so forth, how they prepared for it, because we know Lehman didn't prepare for a further liquidity squeeze at all.

And therefore you created this monster. So the mistake was starting out by bailing out. Once you start down a path, you can't change during that crisis. And they tried to do that, which was a serious error at that point.

Jon Hartley: I'm curious how you think of, I guess, some of these arguments around Glass-Steagall and Gramm-Leach-Bliley.

And a large part that people talk a lot about is separating commercial banking from investment banking. And Glass-Steagall and Gramm-Leach-Bliley and other legislation around that time in the 90s, Glass-Steagall's something passed in the 1930s. Gramm-Leach-Bliley, in the sorta deregulatory period in the 90s, allowed for a lot of consolidation in the part of the banking system.

Some people will say, like Elizabeth Warren will say, Warren will say breaking up the big banks would be a good thing at some level. I think it would make the financial system less stable in the sense that these larger banks that we now have as a result of this consolidation sort of benefit from being more diversified.

They have both commercial banks and investment banks under one umbrella. And if you look at the performance of the larger banks, the JP Morgans, the Citis, the Banks of America and Wells Fargo, I mean, they were generally safe during the financial crisis. And it was, generally speaking, those that didn't have diversified businesses combined that were struggling.

This is an argument I've heard from Bernanke and others or others have mentioned before. I'm curious what your thoughts are I guess on consolidation. I mean, now we're also seeing a non-banking sector sort of emerge that's growing a lot, non-bank lending, think the Rocket Mortgages of the world.

I'm curious how you see sort of I guess the financial system evolving and how consolidations played a role in that.

Thomas Hoenig: Well, let me go back to the first part and that is, you know, Gramm-Leach Bliley, I opposed that at the time and the reason was not necessarily anything against mergers but the fact was the commercial banking industry was the only one that was heavily subsidized in the sense of deposit insurance.

And we knew from other experiences, continental Illinois that they would likely be bailed out if there's a private. And so now you're taking this commercial banking and you're saying, we're gonna allow commercial banks and investment banks to merge. Well that sounds great except you're also then indirectly and sometimes very directly extending the safety net from just the commercial banking industry to the investment banking industry, especially when it's under the umbrella of a single bank holding company that owns both because as a policymaker that if either one of them get in trouble, both of them get in trouble because people, they don't distinguish, they can't be sure how much overlap is there.

And I gave a speech in 1999 as this thing was being passed, saying, you will now have systemic risk for sure, you've invited systemic risk into the financial system and that actually entrenches to be to fail because now everything is implicitly insured. And that's exactly what happened. They say, well, J.P. morgan, the others were satisfactory capitalizing the Great Financial Crisis.

That's not actually true because the US government through TARP, put up in place a $600 billion bailout for the industry. And Citibank, which was clearly on the ropes to failure, had equity injected preferred stock. They gave them enough capital and then if you look at the data, the Federal Reserve made enormous loans to these institutions during that period.

They were provided all the liquidity they need. And that was so called QE1, but it primarily was a liquidity vehicle. I did not object to that because they did have, most of them did have good assets. And when the treasury was done putting equity in them, they all had sufficient capital, but they were bailed out in every sense of the word.

And they had to be because now you had merged banking and investment banking together, these, they were much larger at the time of the 2008 crisis than they were in 1999 or 2000 when Gramm-Leach-Bliley was passed. So you invited this systemic effect and you got it and we have it today.

There's no way you could allow any of those institutions to fail today. And that's going to continue on into the future. And it gives them a huge competitive advantage. And it isn't, it actually is encouraging the consolidation of the industry. I recently was talking to a organization that merged and they said, Tom, we didn't have a choice.

For example, they said when Silicon Valley hit, we had, we were well capitalized, but we had a run on our bank. And they ran to the New York banks, to the too big to fail banks or into Treasuries. And so we had to over and over emphasize we were very well capitalized with very good assets, stay with us and they survived.

But they said we're not sure we can survive the next time that happens. So we've created our own future process of bailouts that are unavoidable and very much entrenched into our financial system today. Which brings me to the shadow banks or the private equity groups. If you think ahead and you, you think about private equity and so forth, they're large enough that I think the liquidity provisions of the Fed will flow through to them if any one of any significant size gets into trouble because they'll be afraid of a systemic fix.

And one of the primary lenders to these private equity, besides how they raise money, are the commercial banks. So it fall back on them, so we broaden the range of trouble. Also, I think there's strong likelihood we'll pass this so called GENIUS Act, which is a law that would, shall we say, put a sanction through regulation on stablecoins.

That is basically money markets that have government securities as backup and they can also engage in payments. And when you do that, I think it's fine to have them if that's what they want and if that's what people want to invest. But once they become subject to government regulation and oversight and people then think they're protected when a crisis happens, the government will step in and bail them out.

And if you don't believe me, think about the money markets in the Great Financial Crisis. The money markets were supposedly backed by very safe assets, the most liquid assets. And yet one of the money markets broke the buck and they were all bailed out. So we're moving away from a market economy.

We're moving away from a government will bail out certain large institutions and certain kinds of institutions. And I think that makes it in the long run. In the short run, everyone wants to be bailed out. And if I had money in a bank that was there, I'd want my money.

However, in the long run we're weakening the system overall.

Jon Hartley: So I suppose in the aftermath of the Global Financial Crisis, we adopted these Basel 3 capital standards for gibs globally systematically important banks. We've got sort of this regime of two types of capital ratios. We've got the, the risk neutral one, which is the supplementary leverage ratio.

We got the risk weighted tier one common equity. And we've also got, you know, a regime of bank stress tests, you know, CCAR, DFAS (Dodd-Frank), these things that the Federal Reserve does. And they sort of have these opaque scenarios that bank balance sheets are supposed to be able to withstand in these simulations.

And if they don't hold up to mustard, they can't issue dividends, they can't return to cash to shareholders. That's kind of the system that we've lived in. I think there's some good evidence that we're in a much safer place now than we were before. Now bank capital ratios are much higher.

I think bank CDS spreads have generally been lower and bank volatility has been lower. And if you look too just in the recent crises periods at some level I think banks held up pretty well during, during COVID and then even during the regional banking crisis. I think it was largely one bank, Silicon Valley Bank, that had some serious problems in terms of managing the duration of their balance sheet.

And then you also had that combined with the uninsured deposits issue, having lots of uninsured deposits. I think that was a one off kind of issue. Sure, there were Signature Bank and some crypto and Credit Suisse was sort of teetering for quite a while but I think by and large things are safer and better now.

I mean, tell me, is that right or wrong in your mind?

Thomas Hoenig: Well, it's relative. I don't agree with you totally, but it is relatively safer. But here's what I would tell you. First of all, the banks are not that well capitalized. They are when you look at the risk weighted capital and you look the amount of risk weighted assets to total assets is about 50%.

So that process weights mortgages at 50% of their book value. It weights other assets at 20 to 30%. And it weights government treasuries at almost nothing. And so you have these very high 13% rates. But when you look at the leverage ratio, how much capital do I have relative to my total assets available to absorb loss?

That's the leverage ratio and it's 7%, 7 cents on a dollar. And in the great financial crisis we lost. The banks lost even the largest, about 6 cents. So you know, there's not that much capital. When you say gold plated, I think that's a word that's been used to convince people to believe them because it isn't true.

They're capitalized better because at the great financial crisis because of the risk weighted system they were about 4%. But there was a time when you had capital ratios of 10 and 11%. And for regional banks they are, they are capitalized leverage ratio of 10%. So it's, it's a relative thing.

It's better, but it's not, they're not well capitalized. And I would tell you, we talked about Silicon Valley and the banks got through it in the economy, but the Fed preemptively pumped hundreds of billions of dollars into the system to provide it the liquidity, the access to enable companies, municipalities to stay solvent, not have a liquidity breakdown.

It did preemptively because you had to run on the banks when Silicon Valley failed. Because when you looked at the balance sheets of the banks at that time, there was about $600 billion of unrealized losses in those balance sheets that were not recorded because of the accounting rules allowing you to not have to charge those off.

So were we really, could we really absorb $600 billion of losses? Well, the idea is, well, they'll basically, you let them amortize until interest rates come back up. Well interest rates were zero for about 15 years. So then they shot up and you had the shock and you have the effects of that.

There wasn't enough capital to absorb that without the Fed. So now the other thing that's happened, Jon, is that the banks, the Federal Reserve's balance sheet, which was once less than a trillion dollars, grew to $9 trillion. But here's the important point. Its footprint in the market, in the government securities market has become enormous.

It calls the shots. And so you don't really have a market there. You have the Fed and one of the, you know, they say that the dual mandate for the Federal Reserve is maximum employment. Right. And.

Jon Hartley: Price stability.

Thomas Hoenig: Well, I was going to say interest rates or something, price stability but they define the Fed defines it as low inflation, not price stability.

And I like to make that distinction there. But here's the main point. They have an unstated absolute mandate: keep the securities, federal securities market stable and able to issue debt. That's, that's their mission and that is a primary mission, their operating procedures are around that. They have a standing repo facility that's around that goal.

There didn't used to be that you had the discount window if you need a temporary liquidity and you have the assets to declare, but now just call them up, it's yours. So we've become, the Fed's become a much more important player in the securities market generally. And the bond vigilantes will only come into play if the Fed sticks to its guns on its quantitative tightening, which it is just about done with, I think, and then we'll see what happens from there.

Jon Hartley: So I guess to speak clearly, so you're diagnosing the banks as not being as safe enough potentially to withstand another global financial crisis today. And, and I guess would your policy prescription be we need even tighter capital ratios for, for the banks. Would that be your.

Thomas Hoenig: Well, I've said this for years.

The banking industry, the largest banks included, the banking industry is over regulated. I mean that's why you have the shadow banks and everything else going on. It's over regulated. And my view was keep the capital high and the rules minimum and simple. Because when the industry was not, didn't have the safety net of the Fed and didn't have the safety net of the FDIC and didn't have the safety net of the government putting equity and capital ratios were 20 and 30%.

Now I'm not advocating for that, but I am advocating for 10 to 15%. And I would get rid of, I mean, stress tests. Come on, I mean they haven't failed a stress test in 10 years. That's process, expensive process. The risk weighted capital measure which the banks favor and the government favors is costs hundreds of millions of dollars, billions of dollars wasted when a simple leverage ratio does the same thing in a much more effective way because it tells you transparently how much can this bank lose before it's insolvent.

It puts discipline out there. So I would have the capital ratios high, give people confidence and get those rules minimized. And I think you would see more business come into the banking industry than leaving. And you'd have a, you can always have a crisis.

But right now the largest banks under the risk weighted system are homogenized and into a single bank there's no differences because the risk weights on the assets define where you put your money.

Jon Hartley: Right? Well, I guess, wouldn't that be a criticism of the simple leverage ratio, supplementary leverage ratio too in the sense that.

Well, you could do to respond to that is just by you could still keep the same overall level of risk for your equity by just investing the assets in much riskier securities or investments. Think buying 3X levered ETFs or whatever have you to compensate for that.

Thomas Hoenig: Yes, I know the argument.

But here's what I tell people. If you didn't have too big to fail and capital was as it's supposed to be. So I want to have a bank, I gather capital now I have to, I'm the management. I'm not the government. I'm the management. And I have to decide how much do I have in riskier loan assets for return.

How much do I have in governments to get a return but provide some liquidity. How much do I have in consumer. Okay, so I know there's risk there, but there's a good return. I have to make those decisions and I have to make them for the long run benefit of my stockholders and my survivability.

But now I know I'm too big to fail. Or creditors know that banks are going to be, they're going to get bailed out even though they invested my lose. So they don't mind putting money into high risk organization because they're sure they're going to get their money back.

You've distorted the market process and, and, and you're proud of it. And I'm saying no, I'm not proud of it, the market gives us in the long run the most effective outcomes. Look at us today. The leverage, excuse me, the risk weighted capital measure is tilted to encourage banks to invest in government debt because you have a ton of government debt to issue.

Well, that's not a reason to have a risk weighted system. And now there's a proposal. The Secretary of the Treasury and each of the agencies have under consideration a proposal to exempt government securities from any capital standard. That's, that's saying, okay, no cost of capital, go ahead and invest in all the government that you, that you want because it's not going to cost you anything.

It's just gravy, isn't it?

Jon Hartley: Just for Treasuries, though, excluding.

Thomas Hoenig: Just for Treasuries. But, that's what I mean. So the government, so the government has a Treasury auction. I'm the bank I lend the government the money. I take the government's securities, the government takes the cash, it spins that money, it circulates back to the bank, so it has the Treasuries.

But now it's circulated back because the government spent. It goes back into the banking system, much of it, not all of it. And I buy another tranche of new government debt. As long as the government has to issue new debt, I'm there to do it and there's no cost to capital.

Well, now you've taken any discipline from the government away to print money. Even the Fed is out of the picture there. I mean, we're going down a road that I'm not sure you ever get back from without a major crisis.

Jon Hartley: Just speaking of, I guess, recent crises.

So we did have this Silicon Valley Bank regional banking crisis of 2023. And I'm curious what you think about deposit insurance, because I think we're in an interesting place there. So, we had, again, you had a few banks, a lot of uninsured deposits, forgot how to manage interest rate risk.

FDIC came in, resolved the banks, but there's still this weird kind of thing which is well, we kind of have this implicit unlimited de facto deposit insurance now. And of course, before you had $250,000 for every bank account. And in theory you could go to every bank in the United States and that would give you hundreds of millions of dollars of deposit insurance.

I mean, I don't think in practice anyone's done that. Maybe, I don't know, but you could in principle. And now we sort of have unlimited de facto deposit insurance. I'm curious, do you think that's, I mean, there's lots of, I guess more hazard issues that some people raise.

Do you think that this is a problem where we're at with deposit insurance and what do you think things should be?

Thomas Hoenig: I think we're past that point. I mean, the moral hazard issue, if you take into account the too big to fail banks and you take into account the reasonably sized regional banks, you may let the investors in the regional banks fail, but you will not let the creditors.

We know that from Silicon valley. So, about 70% or more of deposits are directly or implicitly insured now. So we're only talking about a small percentage, which are primarily the community banks, as we learned that their depositors are not 100% insured, they're the only ones. So I think you have an argument for just 100% deposit insurance because the moral hazard issue off that is going to be that much larger and it's more fair because you've gone down that road and you say fair.

What's fair? Well, if you're going to have a banking industry under the same rules, you better have a banking industry under the same rules. Otherwise you bifurcated it and you've treated some differently and it actually accelerates the consolidation process as you go down the road. So I think it was a very bad mistake.

I also wonder to myself in the Silicon Valley situation I cannot understand as a former vice chair of the FDIC, how you made, you couldn't have made the least cost test for bailing out depositors. It was a systemic crisis test only because a lot of depositors, very large, influential depositors, would have lost money, maybe 20% of their deposit in the end.

And so, you've changed the game. You once again changed the game, and I think that's unfortunate. So, yeah, we have the moral hazard problem, and adding another 20% or 30% to it isn't going to be that much more expensive, given where we are today. Now you have to worry about who's entering it.

But look what you have going on at the moment. You have a whole new system of stablecoin emerging. We have many, many issues ahead of us that will focus the debate about moral hazard going forward.

Jon Hartley: Well, I'm curious, so let's talk about monetary policy for a minute here, because this is, I think, a somewhat related topic coming out of the global financial crisis.

The Fed did its first sort of quantitative easing rounds where they were buying up a lot of these toxic assets and they were helping to resolve bank balance sheets. And so that was, I guess, the sort of initial foray, maybe QE1, I think, is what people call it.

But then if you've asked for it a couple years later, start getting this new process, starting with, I think, QE2, which is the Fed going out, buying treasury bonds and issuing reserves, paying interest on those reserves, and also buying not just treasury bonds, but mortgage bonds too, GSE backed mortgage bonds, buying those, expanding the size of the balance sheet.

And this goes on for quite a period of time. And then in more recent years, the Fed's tried to unwind some of this. Quantitative tightening is what some people call it. And we've had some hiccups along the way. For example, the repo crisis of 2019. The banking system has sort of adapted to this new world.

And I'm curious, you've been a long time critic of quantitative easing. What are your criticisms of quantitative easing in this system?

Thomas Hoenig: Well, first of all, QE1, which was in the crisis itself. I voted for it, but it wasn't even called QE. It was a liquidity facility given the circumstances of the moment and the size of the freeze up in the market.

Jon Hartley: Okay, Judicial lender of last resort.

Thomas Hoenig: Lender of last resort, liquidity provider of last resort. And the idea was that's kind of the theory of central banking for banks that are sound and I won't get into the ones that weren't sound and were bailed out. That we've already talked about but that was fine.

But what I found objectionable was QE2, 3 and 4 all the way through post Covid, because there was this view that unemployment was still high. But in the third quarter of 2009, even before QE2 started, the US economy was in recovery. Industrial production was picking up, employment was picking up.

But there was a view among some that, well, employment was still close to 10% too high and we might be able to bring it down faster if we do QE2. And I said, it doesn't work that way. I mean, bringing people back in takes time. We have a recovery underway.

Let's look at the recovery. Let's be patient because if we go down that road, I said, you won't be able to get out of it. I said in QE1, the whole idea was we're going to do it and then we'll pull back. And instead we're not pulling back, we're going forward with even more, hundreds of billions of dollars more.

And I said, what you're going to do is you're going to set a new equilibrium around zero interest rates and high reserve balances. And they say, well, we're not printing money. Yes, you are printing money, you're printing high powered money and you're keeping interest rates from going negative by having reverse repos.

So you're putting it in over here and you're pulling it over there. I said, why would you do that? Because it provides enormous liquidity into the market to take care of things. But what were the other effects? Because you had this cheap borrowing capacity. You went in and you encouraged speculation.

You encourage hedge funds to go in and buy companies, borrow the money to buy them, strip out the equity and then move them offshore. That's number one. Number two, they said, well yeah, but they'll take, the investors will take that money and they'll invest it in other things like the stock market.

Well, the only thing you did with the stock market, that's not new investment, that's not plant and equipment, that's raising the price to earnings ratio. And that's what they did. So how much more productive did we become? Well, that decade was a low productive decade and a low real increase in wages.

So you accomplish nothing but to distort the allocation of resources, find yourself unable to pull back without having a crisis. You know, the paper tantrum and all that stuff that followed and we're still suffering from it today. And we go, we go past the COVID period and we're bailing, I understand we put the money in and I would have been for it from March of 2020 to August of 2020, but they continued quantitative easing for another 18 months.

And what they did is they increase asset value. So we had further just redistribution of wealth, relatively speaking, because if you held assets, you were richer, if you didn't, you didn't gain much. And what do you, what, what else did you sow? Societal unrest because people were saying, wait a minute, this isn't fair, I want mine, I want mine.

And so now we have a government spending $6 trillion a year, issuing new debt of $2 trillion because everyone wants theirs and it's not going to end well.

Jon Hartley: Well, I'm curious about like I've heard those same arguments from QE critics in the past. And I’m curious, what about this for a different argument that QE largely awash, in the sense that, sure, the Fed goes out, buys some 10-year longer-dated Treasuries, maybe they decrease the yields on those by 20 basis points, 30, 40 basis points, I've done event studies myself.

Other people have done event studies that find some small but meaningful effects to that extent. They issue some reserves. At some level they're taking in treasuries and long term maturities, issuing essentially very short term maturities or reserves. And it's kind of just swapping one hand for the other.

I'm curious what you think about that at some level too. I think that there is some conflation in my mind. I don't buy the argument that quantitative easing is responsible for the run up in US equities in the past decade and a half or so. Because I think you look at the US compared to say Europe, Canada, Japan, a lot of these countries, Europe, UK, Japan, they've had just as much quantitative easing as a fraction of GDP.

And those places have had stock markets that are essentially flat for the past 15 years or so that haven't seen almost any return. Their GDP per capita has been extremely flat as well. I think the difference between the US and those places are largely the US has this massive tech sector that's very vibrant and we can debate why it has that, but it has it and these other countries and regions don't.

And if you were to strip out the earnings and the productivity from the tech companies in the US, you probably would see a US economy that looks pretty similar to Europe, UK, Japan and maybe Canada. I'm just curious what your thoughts are on that. That like the inequality thing might not necessarily be what's going on.

I buy the whole, once we're in this thing, it's very hard to get out. And if you were to get out of it, you'd need a Fed chair and an FOMC that is extremely laser focused on doing it. Even if it did upset investors, they'd have to communicate extremely transparently.

But yeah, the whole inequality thing, QE, I've never really bought.

Thomas Hoenig: Well, first of all, we'll have to see how it all plays out in the end. But number one, I would say, you know, frankly, Europe, Japan, Canada, they all did quantitative easing, you're right.

And a good part of that strengthened the dollar as they invested in our tech. So the money did move, it moved in it. But the other part of it is okay, so you want to argue about it didn't, it didn't matter relative to equities, housing, other assets, both here and in Europe and Canada, inflation, they all have experienced that.

And that didn't happen because we reduce the amount of money in the economy, the nominal GDP numbers are all up nominal-wise, even though sometimes productivity isn't as high and so forth. So I mean your market signals have been distorted, the relative cost of capital has been distorted and the effects have been, I think for the most part damaging.

And if you didn't have the QE and you still had the technology, yes, they may not carry the values price to 200 to 1, price to earnings or price to book, whichever, but they would still be very successful companies. You didn't need the money printing the QE to make them successful.

That's not why they were successful. And therefore that doesn't excuse the fact that we've expanded the wealth difference in this country across the board, not just in stocks but in every asset held. I don't see any good outcome from that.

Jon Hartley: I guess on the inflation point, I've always associated the 2020s, early 2020s inflation more so with, I guess, the fiscal policy and transfers that hit all these people's bank accounts, whether it's the economic impact payments in the US or PPP loans and so forth.

I guess, looking at how the Fed performed during that period of time, do you think that the Fed made a critical mistake by not raising rates early enough when it was very apparent, say by October 2021, that the inflation story wasn’t purely about used car prices jumping, and that it was very broad-based and involved housing rents?

I'm curious what you think about how the Powell Fed has performed in recent years, how they responded not only to the great inflation, but also to Covid. I mean, how would you rate them in that sense?

Thomas Hoenig: Well, in terms of the response to Covid, they did more than they needed to do, but I wouldn't criticize them.

I mean, in a crisis like that, you do what you have to do. I'm not going to criticize them. I think after August, when we knew that recovery was underway, then it was clear that they should been they didn't have to, they didn't have to shock the economy.

They just, instead of 120 billion of new reserves a month, weaned the economy off that gradually. Rates didn't have to be zero after a while. I mean, they didn't have to be five and a quarter percent either, but they could have been higher and you would have had a transition that I think would have been more successful rather than a shock that we had to take.

Now I think they also made a mistake using the word transitory as long as they did. And, everyone tends to agree with that, even them. So I think had they made their moves more modestly sooner, we could have had a smoother transition than we had. But at least they moved this time as opposed to after the great financial crisis, and I give them credit for that.

Jon Hartley: Yeah, no, it's amazing and interesting to see just how much has changed just in the past few years. I mean, do you think that the Fed maybe under the next Fed chair, whether it's Chair Kevin Warsh or a Chair Scott Besant or someone else? I mean, do you think that we will ever in our lives get back to a reserve neutral system or a world where we don't have a QE balance sheet any longer?

Do you think that that will ever happen or do you think that the political economy problems are just too big? I mean, there is this problem which is when you're at the Fed and you're tightening sometimes that when you cause disruptions in financial markets, my sense is that there's always this temptation to ease and turn around, just like the Fed did in 2019 in response to the repo crisis.

I'm curious what you think in, through the long run, whether we'll ever get there or whether we'll be able to solve our too big to fail issues as well.

Thomas Hoenig: I think we're on a path that it will take enormous leadership, not just at the Fed, but enormous leadership in this country to bring us back to a more neutral kind of policy era.

For example, I do agree in 2019 that was a bailout for certain groups, if you will. I think it's very hard not to bail out when you're under that pressure. And let's, let's think about the Future. So the US government has to fund $2 trillion of debt every year or more going forward.

So where is the money going to come from to fund that debt? Well, because of our tariffs, war potential war or war, whichever way you think of it, foreign entities aren't going to be as for the least, for what I can see, as anxious to fund that debt to have those government securities.

I hear Europe talking about portfolio of reserve currencies and so forth, I have other. So there's less demand there. The bank industry is loading up on them now. Who's going to buy it? Who can print money to buy it? Only one institution that I know of, maybe two, given that there's no capital requirements and no reserve requirements.

And that would be the banking industry and the Fed. The Fed can print the money or by buying and recycling the treasury money, it can be what I call the shadow central bank and print the money as it multiplies up. That's the future. And what follows that?

Well, either a crisis that brings it under control or inflation which has another form of crisis that brings it eventually forces it under control. That's not an outlook I really want at all, but I don't see it any other way unless the leadership says, yes, we're going to, we're going to scale this back.

Yes, we're not going to print money for a while. We're going to go through that transition. But in the long run, I think we'll have higher productivity and we can maybe, maybe bring our debt under control. It's pretty hard to bring under control now because the amount of interest we're paying on the debt and so forth.

So it's going to take a lot of willpower and a lot of leadership. Or we'll wait and have a crisis. tell us what to do. That's my thinking.

Jon Hartley: Fascinating. Tom, I really want to thank you for coming on. It's been a really amazing conversation.

Thomas Hoenig: Well, I enjoyed it, and great questions. I wish I had perfect answers for all of them, but it was a great conversation. Thank you.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy.

I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Kyle, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Jon Hartley, your host. Today. My guest is Kyle Bass, who's a legendary investor who famously predicted and bet on the housing collapse of 2008.

He's the founder and principal of Hayman Capital Management, a Dallas-based hedge fund focused on global events, and the founder of Conservation Equity Management, a Texas-based private equity firm focused on environmental sustainability. Welcome, Kyle.

Kyle Bass: Glad to be here, Jon.

Jon Hartley: Kyle, I want to just start by getting into your early life. You were born in Florida. Your dad was a career tourism executive who helped manage the Fontainebleau in Miami Beach (it's actually one of my favorite hotels) as well as the Dallas Convention and Visitors Bureau. You went to TCU where you studied finance and real estate. You worked at Bear Stearns, the Dallas Office.

In the 90s, you started the Legg Mason office in Texas. How did you first get interested investing, global macro and geopolitics?

Kyle Bass: Boy, look on the investing side. I was a chemistry major. Going in, I thought I wanted to be pre med and then I ended up taking a non major elective in options and futures.

And I read the entire course book in a week and changed my major that week. It hit me that that was clearly what I wanted to do. It was just a moment in time. My junior year in undergrad, I grew up in a family where I had a great mom and dad.

They didn't save any capital for retirement or for school. We were kind of call it lower middle class. We were on a hotel manager salary and when we moved to Dallas, we worked at the convention business bureau. So I had a good life. It wasn't a silver spoon, that's for sure.

And so, you know, right, right out of school, I, I was just enthralled with financial markets. I was always a math and science guy. There are those two, I guess you're probably all of them, John. You probably have the, the, the, the ability to assimilate language and reading and, and math and science.

I was always a math and science person. So it was a natural progression.

Jon Hartley: Well, it's, it's amazing. And I know you're in my mind having followed and your thinking for a long time. I think you're a real icon of the Dallas finance community, which is something that has grown a lot in just the past few decades and even just recent years.

There's all these firms now that are moving from, say, New York or California to Dallas, I think Toyota and so forth. But also all these banks are setting up their second headquarters there, Goldman Sachs is building a big office there. But you were there at the beginning of all this and all these early shifts and moves to Dallas early on.

So I commend you for being a staple of Dallas finance and for not having left as well, like many people might. I want to talk about the financial crisis because I feel like the financial crisis was just a defining moment for many careers in finance and perhaps including yours in terms of, I think, your skyrocket to fame.

I mean, you made these bets against the subprime mortgage market through Hayman, and later you testified to the Financial Crisis Inquiry Commission. I mean, how did you first come to start thinking that there was trouble with the housing market in the US in the 2000s and that it might end up in some sort of catastrophic state?

Kyle Bass: Yeah, I think that. First of all, back to your question, the prior question about what got you into the financial markets? What do you care about? When I was at Bear Stearns, I worked on Bear, had a risk arbitrage department, you know, where I think they were one of the best and call it institutional risk with mergers and acquisitions and things like that.

I was always a special situations analyst, meaning, you know, I was, I was kind of a technology. There was no vertical where I was an expert. It was just trying to dig into each M&A situation, each spin off, each bankruptcy, try to understand the operative parts, I. Just whiteboarding these things.

So, you know, when you whiteboard something and you dig in, you just have to have a deep intellectual curiosity, which I also know you have. And you can't teach that in the kids into employees. I believe they have it or they don't. And having that deep curiosity for how things work, what are the proclivities of the players?

And then how do you handicap, you know, the potential outcomes? I think again, on Wall street you only need to get like 55% of those, right, Jon? So I think that as. As we got into the launch of our firm. So I launched my firm in January of 2006.

And at that time, you know, Asia was exploding, that China just entered the WTO in 2002. It was a big moment in time when, when money was really flying into Southeast Asia. At the same time, we all knew that our housing markets, I mean, everyone knew the housing market was overcooked.

Everyone knew that it was really easy to borrow money. And as you know, you didn't even have to have a job. Bartenders could have two or three loans. I went to Abs west out in Las Vegas, and I was sitting in a Bellagio bar waiting for friends to go out to dinner, and it was just me and the bartender.

And I said, how's it going? She said, well, you know, it's going fine, but, you know, my, my houses are killing me. And I said, what do you mean, your houses? And she said, you know, I have three homes that I've been able to buy here in Las Vegas, and I rent them out.

But, you know, my, my tenants are giving me trouble, and they. They turn over too fast, and I'm like, whoa, wait, how do you buy three houses? And she said, well, they just ask for a loan and they just give you one. And literally that happened while I was sitting at the bar.

And it's much deeper than that. But that was just an anecdotal, you know, confirmation of what, why I was there. I'm thinking, you know, it's crazy that a bartender can have three loans. And so the intellectual curiosity was, okay, how big is this? How much capital is out there in a disassociated risk paradigm?

Because that's basically what it was. And then you have to figure out, well, how does that play into leverage structures? You know, levered hedge funds just blow up. Well, that's fine. That's not a really systemic problem for the, for our. For the US Financial system, and what does it do to the banks?

And then once. Once you started. Once I started going down that rabbit hole, you realize that, you know, Lehman was 36 times levered, and they had a huge amount of this stuff on their books. Merrill had, you know, 50, 60 billion of this in a warehousing facility. You know, Bear Stearns was 29 times levered. But you lever yourself 30x and you end up owning assets that lose, you know, 40% of their value. And you can do. It's just a math problem. And so, you know it. I came to the conclusion that the whole financial system was in real trouble and went to meet with people at the Fed, went to meet with people like Professor Ken Rogoff at Harvard, who at that time hadn't written his famous book, but as you know, he was kind of the father of sovereign balance sheet analysis.

So again, I'd go out and meet with people and say, talk me off the cliff. I would say explain to me how I'm wrong, please. I need to know this because if you remember once, once everyone became aware of the situation, we were all wondering where money was safe.

We were actually wondering where our savings were going to be safe. If it was going to be safe in JP Morgan or Morgan Stanley. Well, I guess Morgan Stanley wasn't a bank yet, but they had to become one. It was just this moment in time where intellectual curiosity and the ability to analyze special situations came together.

Jon Hartley: That's amazing. And I guess you've also made some successful bets too against Japan and Greece. Speaking of sovereign debt crises, how did your thinking around those come about? That's sort of around roughly the same time period.

Kyle Bass: Think about this. What precipitated the crisis in Europe was of course the financial crisis in America.

And if you followed when the US decided to bail out its banking system, you had to follow the bad private assets to public balance sheets. So then the analysis was which public balance sheets can handle that kind of movement of that many bad assets. So the US could handle it.

We lost about 800 billion. So our banking system had a trillion of equity back in 2006 we had 17 trillion of on balance sheet assets. If you just, just look at banking assets, not the non banks. So we are about 1 times GDP in our banks, we had a trillion of equity.

We lost about $800 billion. So we recapped our entire banking system through common and preferred equity injections. So we actually did it right and recapped the system and got going. Europe couldn't recap the system and they had a worse problem than we did some of their banking systems.

Because of the EU, Iceland and Ireland both had 10 times their system, 10 times their GDP in their banking system. So it's the same problem that the levered hedge funds and Lehman and Bear had as a country. They took on way too many banking assets because they were chasing deposits all over Europe.

And so Iceland and Ireland fell in pure succession and then Greece. And so it was kind of a logical analysis of a balance sheet that just went from corporate balance sheets to sovereign balance sheets and then from there. How many things have you ever read in your economic career that say so and so ex Japan, so and so, you know, Asia ex Japan, ex Japan, ex Japan.

Because Japan blows every Gaussian distribution you've ever seen, right? They're like they're so far out there and they're so far that they, that if you include them in any mean it ruins the whole mean. So they just exclude Japan. Well, I started looking at Japan, I said, well how do they do this?

How do they, hang on, how do they take at that time 200% sovereign debt to GDP on balance sheet? Well, the answer was they had to take their rates to zero and negative and they have to leave them there. And so today Japan still has rates pegged out to 10 years and they're letting the 30 year kind of flap in the wind.

But the real answer is now they're 265% sovereign debt to GDP. They can never let rates move. They can't. So what does that mean? That means the currency is the escape valve. So when you characterize where we launched a fund quote against Japan, it's not the case. That's kind of folklore.

What we did is I said one of two things has to happen here in this analysis. Either Abenomics has to come about and Japan's got to inflate their way out of this problem and try to get some growth or they're going to be crushed under the weight of their debt in their own system.

That's really, they hit a fork in the road. And so we took two thirds of the money in the fund and we bought bond market optionality right in the, in JGBs. I took one third of the money and I bet with the bank of Japan on their ability to weaken their currency because they had to do that.

So when we launched that the yen was 85 to the dollar. Their bond market was where it was. And then Abenomics happened, when Abenomics happened, it took the yen from 85 to 120. You could have done the back of the envelope math. So we lost 2/3 of the money and on the other third of the money we made many multiples of that capital.

The fund ended up making, you know, 250%. So you know, was a bet with the bank of Japan on one side and it was a bet against their ability to hang on in the bond market if they would ever let it go. So it was just the right economic bet at the end.

Jon Hartley: It's amazing, yeah, I mean the whole story of Japan is I think a super interesting one. You just, when you think about it, and it's something I've been reading a lot about and saying a lot, I feel like Japan is kind of strangely ahead of the US and the western world maybe by a few decades or so.

Kyle Bass: Exactly right.

Jon Hartley: The sort of asset, you know, bubble some people call it, but really just the collapse and flat GDP per capita there that began in the 90s. And you look at most of the Western world except for the US now it's had flat GDP per capita since the early 2010s.

But even other topics, things like industrial policy, that was something that Japan is perhaps famous for.

Kyle Bass: In the 80s they were doing so much lending that the Basel 1 accords had all to do with containing the Japanese banking system and constraining their equity ratios at that time.

Jon Hartley: So it's a fascinating. They were first at quantitative easing. They're I think still the only central bank that's actually bought up stocks. So they're very interesting and instructive I think for a lot of reasons. First company to really go crazy on debt to GDP in sort of recent times.

First advanced economy and 250% debt to GDP and now their bond yields have been skyrocketing just recently up to the 30, 40 year bonds have been jumping in yields. And I guess there is, I guess you could call it this financial repression sort of issue. Or you could call it fiscal dominance really, where there's this challenge where they can't let interest rates rise because their net interest costs will just totally balloon.

I mean, do you have any thoughts on Japan and like if there is some sort of a sovereign debt crisis looming, is Japan the first to go? And does that end up being some sort of a domino in your mind?

Kyle Bass: You know, I, I don't, I think Japan's got it under control. And I mean in a way where you have a, if you have a population that has a significant, you know, the. Japan has one of the oldest populations in the world, Japan and Italy. And they've got a demographic crisis, right? They've got a crisis where it's really difficult to grow your sovereign.

If your population, your call it endemic population is not growing. And so they're not. There's a fascinating, there's a fascinating thought to have here and it's one that I haven't really discussed that much. But when you think about fractional reserve central banking, which is the way we all operate and Japan is a poster child here.

I have a theory on why the demographic curves are hooking down in the US in Europe and in China and Japan. So if you think about the way these systems work is they typically, by the way, almost no sovereign ever defaults, Jon. They get into a crisis, they print and print money, expand a balance sheet, but they always pay.

They rarely if ever stopped paying. So we get into a situation where you look at where Japan is, and if you engage in this type of central banking activity and you kind of lose your fiscal moral compass to where you just run huge deficits and you print the balance and you suffer inflation.

If the men in your economy, when they graduate university, can't afford to buy a home, they live with their parents, they're not having sex, they're not having kids, they're not marrying. So when you look at the marriage rates and you look at the fertility rates of the average women across not only the developed world, in China, when real estate prices rip and wages don't go with them, you create yourself an endemic problem in your economy.

And so Xi Jinping has figured this out. He figured it out when he said financial security is national security. Note, he has not stimulated his real estate market. When home prices in China got to be 26 times median income, the men couldn't afford homes. So the demographers had this arc of the demographics of China, Japan, the U.S. you know, arcing out to 2050 and heading down around 2050.

And now they're all collapsing. The reason they're collapsing is we just injected 50% inflation in dollar terms into the world. And that's our demographic curve here is hooking down. Europe's was already hooking down, Japan's was already hooking down, and China, China's demographic curve collapsed. So the way that we operate our central banks and the way that we kind of financially engineer, I, I heard you almost say financial repression in Japan.

The way that we financially engineer our economies has consequences. And those consequences are we, we both know that asset prices far exceed wages. And so real wages have been massively negative, even though the Fed is not saying that. The reason the Fed's not saying that is because they chain weight inflation.

So if you look at it in reality, asset prices have extended themselves to where it's not, it's not conducive to procreation and families. It's just fascinating.

Jon Hartley: And yeah, and you think about zoning too, and, and you know, 90s regulations, which is sort of pervasive in, in most countries.

I mean, Japan being one exception, some Eastern European countries, some, some exceptions. But, you know, real estate has become so expensive, prohibitively expensive around the world. And I think, you know, that to some degree is causing, you know, there's some empirical evidence that that has negative effects on fertility.

I mean, that's not a surprise, people can't buy their own homes. They can really get married and have children. So, you know, it's, it's amazing how quickly all this land use regulation and how quickly real housing costs. If you think about home prices over the past 150 years, if you look at like the case Shiller index and you net out inflation, that trend is like basically flat from like the late 19th century, late 1800s up until like the 1970s and 80s.

And it's just on a total upward trajectory and zoning, some people say it's other things, but you know, regardless of the cause, it's hugely prohibitive, especially, you know, for young people.

Kyle Bass: Well, and then there's another natural progression, if you're intellectually curious, if, if in fact that's the case.

And you look at FHFA zone index, the US government's own unchained weighted housing index was up 50% between 2020 and 2024, 50. So wages certainly are not 50 between 2020 and 2024. If you follow that naturally to the, to call it the next node on the, on the timeline.

All that does is it tears the social fabric of both our country and the world. So the poor state, the poor were already poor. They didn't have any discretionary income. So it, it makes them much poorer on anything they have to acquire to just stay alive. Call it food, rent, inflation, or gas, whatever, whatever you're doing.

And then it prices the middle class out of being mobile. So it immobilizes the middle class. What does that do? Well, it creates tension because it ends up in the richest hands. And so that gap widens. And what does that do? Creates tension and in some places it tears.

And that's why we're having more wars. So, you know, you have, you have a scenario where the central bankers believe that it's the answer. The answer is just, let's just keep growing these balance sheets and kind of just not focusing on being more fiscally responsible because they can.

And then what that does, though, is the follow on effects of what's happening here. Our inflation, our tearing at social fabrics, our fertility rates collapsing, and then war. It's actually what happens and that's what's happening now. And we should expect more and more war because there is no answer for this equation at the moment.

Jon Hartley: So I want to shift just to China now because you're very outspoken on this. You served on a lot of defense boards, you're very involved in the military community, your lifetime Council on Foreign Relations member. And I think it's fair to say that some people would call China hawk and have been critical of the Communist Party of China for quite a while now.

And in particular what it's doing with respect to Hong Kong and Taiwan. I'm curious, what's your sort of overall thesis on China, US decoupling and your thoughts on the role that say, defense tech and investors play in this? Because I know you're, you're involved in this space as well, not just as a policy expert and thinker, but also as an investor.

Kyle Bass: Yeah. Well, thanks. Look, some call it China Hawk, some call it China Realist, you know, going to the lengths of understanding how the architecture of their system works and that we went from Japan to China between 2012 and 2015. I put my whole team on China. And this starts empirically with me calling all the Wall street firms and saying, someone send me your primer on the Chinese banking system.

I want to understand how their domestic, since they have a closed capital account, I want to understand how the Chinese RMB or offshore CNH and the USD interact. I want to understand the architecture of their system. And no Wall Street firm had a bank primer for Chinese banking system.

No one had done it. They were selling stocks, everybody was buying and selling stocks and via structures and whatever they were doing, but no one had actually sat down to do the work to understand how is the system built. And so that's how I got deeply involved in understanding not only the architecture of their system, but invariably what that does is it takes you into cultural preferences, cultural norms, then that invariably takes you down the history route.

And like, how did they get there? What are the incentives of the players? Why does Xi Jinping care to just have the iron fist and the five tools of Democrats dictatorship in one hand? And then, then you understand what their grand strategy is. And when you understand what their grand strategy is, it is completely incompatible with ours.

And so in 2016, I came to the conclusion that we were certainly going to be in conflict with China at some point in time. So it's actually easy to see if you apply yourself. And you understand. So on the defense side, you know, we're talking today, and I know this isn't just for today, but this is the day that Israel attacked Iran's nuclear facilities.

You and I, Jon, have talked about that. That event was going to happen. Iran was not going to let everyone into their new centrifuges and all of a sudden become compliant with the rest of the world. They're the largest state sponsor of terrorism in the world. So this attack was obvious that it was coming.

China has told us since 2017 that they are certainly going to take Taiwan by force, if not, if necessary. They continue to send more delegations over to the US to tell us this. They continue their air defense zone incursions into the Taiwanese air defense. And if you chart it, you can see that every year it's more belligerent.

So it's coming. And then how do we think about our relationship with China? Well, you know, I was just recently in a, in an interview where someone said, well, the CEO of Ford says if they don't release these, these very specific rare earth magnets, then we can't put our EV engines in our cars. We're just going have to shut down, the sky's falling. And I say, well, it's obvious since 2017, it's been written on the Great Wall, what, what's coming. And you as a CEO should have seen that. And it should be obvious to you that you shouldn't rely on China for your supply chain.

So I have no sympathy for these people. But when the question you're asking is what happens? I think you're going to see China invade Taiwan and forever change the makeup of the economic relationship between the west and China.

Jon Hartley: How do you see them doing that in the sense that there's some, I think at least maybe a couple hundred US military personnel that are there.

They're, do you see them sort of cutting off Taiwan with some sort of a blockade and trying to starve them out? Do you see it being some sort of a land or some sort of an incursion, amphibious incursion, all at once, that sort of overwhelming attempts to overwhelm Taiwan?

What do you think the US response would be in that kind of scenario? Do you, what do you think that would all look like?

Kyle Bass: So I think there are three paths. The first path is the soft path. That is like the way that they took Hong Kong is, you know, this is going to sound tin, tinfoil hat like, but let me, let me give you just a hypothetical.

So the Chinese Communist Party before they took, before they took Hong Kong. The Hong Kong protests were at their peak and December 2019, the Chinese current account, call it their net income account, was headed towards zero there. They still had a positive trade balance, but they had a lot of external capital flows and we're going to get into that later.

But, and so they had this existential crisis with Hong Kong and the legitimacy of the Chinese Communist Party having to fight an uprising in Hong Kong at the same time, a current account headed towards zero. And what happened magically Covid happened, it came at the exact perfect time for the Chinese Communist Party.

It took their current account plus 250 billion because they shut off international travel for their population and they dialed back the school expenses. All of those are in dollars. And they were able to take over Hong Kong without firing a shot. Everybody went home. So the soft side of the Taiwanese situation is, you know, the KMT is funded by China.

China is hoping they can get the KMT in there. They really hoped this last time, but William Lai won. So the question is, what happens in 2028? Does the KMT win and does Xi Jinping Wait until 2028? I believe he can't. There are those in the US that believe he's going to wait to see if they can take it over with soft power as opposed to hard power.

So the three options are soft with the KMT winning in 28, the two other options are blockade, as you mentioned, or all out assault. One would think that a blockade would, would actually force the US to unblock the blockade so that China could claim to be the victim.

Right? They are. They, they have a PhD in victimology in the Chinese Communist Party and they're the best in the world at being the aggressor and claiming to be the victim. So in a blockade scenario they would just blockade the west coast of Taiwan. And as you know, Taiwan's very much like Japan was in World War II.

They have no natural resources, so they've got two weeks of energy on island. They have to import their energy and their food every day. So they're very dependent upon those ports and especially the southernmost port. So a blockade is not going to be that difficult. It's going to require us to unblock it.

And I think we will unblock it. And then, then we're in, then we're in a kinetic conflict. The question is, and then again, option three is just the all out assault of the Taiwanese island with an aerosol amphibious assault. And it's difficult. You know they're, I'm sure you know the terrain.

There are, there are 22 foot tidal surges in the Taiwan Straits 110 miles wide, the largest amphibious assault in the history of the world was D Day, which we just had the 81st anniversary of about what seven days ago or so. So this is a much, this is a much more difficult amphibious situation.

The tides being 22ft and changing title surges in that Taiwan, Taiwan Strait lends that lends it only to be somewhat amenable to an amphibious invasion three months out of the year. And so there'd have to be precision and timing as to when they go. There would have to be precision and timing on their on island position, but then on island, as you probably know there are two giant mountain passes, there's a Thermopylae problem and so there's all kinds of problems with an assault.

So I think they'd rather take it on the soft side or through a blockade instead of an all out assault. But the US we have plans for all of that. We don't have a great plan for the soft power takeover the either of the hard options. We have the most capable and best kinetic military in the world to this day and we have plans.

So you know, it's, let's hope it doesn't get there, but it sure looks like it's going to get there.

Jon Hartley: I want to talk I guess just a little bit about US-China relations and how it's evolving, particularly with respect to economics, trade, finance. And when I think about like say go back 10 years ago, the mid 2010s, you know, we had on the trade side all the western powers in Japan were I think trying to get China into the TPP.

This is prior to the 2016 election cycle where Hillary Clinton was forced to recant her support for the TPP. This trade, Asia Pacific trade deal, multilateral trade deal and those largely brought on by Bernie Sanders, his candidacy obviously Donald Trump is president. Trump has totally changed thinking on trade in the Republican Party.

Both parties have really shifted on trade broadly speaking. But I think there's been also just this massive shift in thinking about China in general. And I think a lot of this had to do with in the mid-20s. I remember sort of my wake up call to China, or at least a big part of it was seeing these videos of the Uyghurs and how they were being treated and these very, very serious human rights abuses.

And I think that really, I think woke a lot of people up to what was going on in China, that it wasn't this sort of peaceful, friendly, inconveniently dictatorial kind of nation with archaic communist system, but was very friendly economics wise. And then Xi Jinping was transformational in that shift as well, taking things on a very different track from Hu Jintao, who's in power in most of the 2000s.

But now we've seen China's really backing off on the one China, two systems idea to sign a British joint declaration where China agreed to allow Hong Kong to keep its executive judicial legislative autonomy until at least 2047. As you mentioned, China moved on Hong Kong during COVID I'm curious what your view is on all this in the sense that I remember in the 2010s in the BRIC economies, that was really one of the biggest investment themes in emerging markets. And China was a huge part of that, I think if you're investing today, if you invest in China from that time to today, we'd be maybe flat or something like that. Certainly in Hong Kong, there are all these things that China connect and all these things, all these things trying to get people to invest in China.

I'm curious, in your mind now, there's issues around rare earth metals and so forth. Where do you see all the sort of U.S.-China economic relations going? Obviously tariffs have been a, a very big story in the past few years as well. But I'm curious, where do you see the U.S. economic, U.S.-China economic relations going on all these sorts of avenues?

Kyle Bass: Yeah, I look, our systems are fundamentally incompatible. Our values, we, we don't share the same values as the Chinese Communist Party. In fact, ours are diametrically opposed. We want to empower the individual. We have basic property rights. We have free. There's a joke in free in China.

There's free speech in China, but after you freely speak, you won't be free any longer. Right. So there's the, there's the value system that has a complete lack of compatibility. And we all want to say, well, they'll learn, they'll learn to open up. They'll learn that when you look at the bright shining star of Taiwan, think about Taiwan just ideologically, why does it bother Xi Jinping so much?

Taiwan is like a Chinese democracy that's embraced western capitalism. Taiwan's GDP per capita is 300% what China's is. So Taiwan is what China could be if it embraced Western values and Western capitalism. You and I both know you want to see meteoric growth. You get China to open up and you get China to have an open capital account and embrace Western values and, and stop lying, cheating, stealing, cajoling your way through the world.

That's just, that's the way they operate. So you, you said you kind of had your, your Sputnik moment on China was, you know, it sounds like the images of the Uyghurs and understanding what was happening over there in East Turkestan. That was one part of, of my awakening in 2015, 2016. But the other one that really, you know, I don't know if you've read Unrestricted Warfare, once that got printed in English, you know, that was written by two Chinese generals, that was written for the Chinese military and it made its way into the popular, not really popular, but into the policy circles and think tanks.

People got a hold of that book. But DIU wrote a piece in 2016, the Defense Innovation Unit, and it was written by Mike Brown. And for me, that was my holy shit moment, pardon me, I don't know if you're allowed to do that on your podcast, but you read this, you read this 2016 DIU report and you're thinking, I like, I knew it was bad.

I didn't realize it was that bad. It talks about how they steal 300 billion-ish of IP from us every year and earn a return on it. It shows you how they infiltrate the venture capital companies in Palo Alto and on Sand Hill Road and how they intentionally make investments in information technology companies that hope to sell their wares to the largest information buyer in the world, which is the CIA.

But if they're Chinese investors in there, it basically takes them off the map. So if you, I don't know if you've read that report, it's a phenomenal report. Then there's a follow up report from DIU but it's a very comprehensive, specific analysis of Chinese economic statecraft in America.

And that did it for me. Trying to, after understanding their system, after understanding their basic complete refusal to, to embrace human rights of any kind. And then you understand the way that they're operating their economic statecraft. And they are our mortal enemy, John. They are not a competitor, they are not a trading partner.

These most recent negotiations that we just had, how many times did you hear, well, they have these rare earth metals that we really need and they have these rare earth magnets that are needed in every single EV. And I mean, we kind of have to deal with them.

And I kind of jokingly said a couple of days ago, I said this is not a trade negotiation, this is a hostage negotiation. We need to bring in hostage negotiators because that's what we're negotiating with China. And that is not a positive economic relationship. We're not talking about, hey, you charge us this tariff on agriculture and we charge this on cars, why don't we just like find a great place to be and, and move forward?

That's a trade negotiation. What we just had was a hostage negotiation. And how can that be positive going forward? So I think we're going to see Xi Jinping move in the next two or three years on Taiwan. I think we're going to be kinetically involved. I hope it doesn't involve nuclear, a nuclear transition transaction with either tactical nukes or something like that.

We're two nuclear powers, the world seems to believe that we could just fight in the Taiwan Strait and not take it to the Chinese mainland. I think that is, I think that's short term thinking. I think that you and I both know out of Fujan they're going to launch surface to air missiles, surface to surface missiles, and then we're going to have to attack military installations in Fujan if it happens.

So if you believe that that's even a possibility. And you asked about investing, first of all, investing in communism has never worked in the long run ever. Number two, if you believe that China is our enemy and that we might be at a kinetic conflict with China in the coming years, why on earth would you invest dollars in anything Chinese?

Jon Hartley: You know, it's, it's, it's fascinating. Just, you know, when I was in my time working at Goldman Sachs, China was still a theme and you know, things like China a share and you know, each year, all this, all these sort of vehicles to get exposure to China and all this excitement about it in that sort of 2000s, even early 2010s period.

Kyle Bass: It was a good, it was a good bet back then, Jon, because teaching them that Westernization and embracing some of these values would grow their productivity and their GDP per capita. It was a great bet back then. At some point in time it became a bad bet and we must admit it.

And now we must explain to the world that they are our mortal enemy.

Jon Hartley: I mean, Milton Friedman, I think, famously made, in part it was a prediction, and he recanted it later on. But those that countries with economic freedom will inevitably develop political freedom. And yeah, I think it's fair to say that since Deng Xiaoping, China's certainly become more of a capitalist economy now.

There's a lot of caveats to that and there's a lot of state control in all over, all over its economy, its banking system elsewhere. But I guess in your mind, do you think there's any way that somehow there's political uprisings in China in our lifetimes that we see, and obviously this is something that's always on the minds of the Communist Party of China, but it's such a large country, it's a fairly decentralized government.

There's lots of different regions and lots of different peoples as well, and some various ethnicities as well. I'm curious, see, in our lifetimes could there be some sort of an uprising in China or some sort of regime change in your mind?

Kyle Bass: Yeah, I think it's likely to happen.

And I think again, logically, if you understand their grand strategy, understand the composition, architecture of their system. They built their system. Their system was flawed from day one. Their banking system is 320% of their GDP. There are two Chinese banks that have more assets than JP Morgan. You know, the US economy is 26% of the world economy, the Chinese economy, so we run about a $30 trillion economy.

They say theirs is around 18 trillion. It's about a little bit more than half of ours. And yet they have two banks larger than the biggest, best bank in the world. I find that to be interesting. So I think you get to a point where if, if the architecture is flawed, if their leadership is hell bent on staying with a closed capital account and being belligerent with the rest of the world and partnering with the axis of authoritarians, right?

You've got China with a limitless partnership with the war criminal in Russia. You have China, China partnering with Iran, you have China partnering with North Korea. So all four of the big authoritarian governments called the axis of evil are all working together this time. So at some point in time, what's going to happen is when they go kinetic, John, we hold all of the cards.

We have their ticket into the world financial system. They have four joint stock, they have four SOE banks, 12 joint stock banks. They have an Achilles heel or two, and we know exactly where they are. And I can tell you when they move on Taiwan, sending carrier strike groups in the Taiwan Strait is one thing we may do, but we will certainly hobble them financially.

And when we hobble them financially, it's going to be hard for Xi to hang on.

Kyle Bass: So back to your regime change question. Like that's, that's likely the progression of that regime's exit when, if and when he goes kinetic.

Jon Hartley: Yes, so I guess speaking of other sort of non-democracies and forming alliances with some of them.

I think the Middle East and some of the recent foreign policy positioning certainly with the US and growing closer to various Sunni nations, thinking Saudi Arabia, UAE. And thinking about the Abraham Accords and building bridges between Israel and some of these Sunni nations. And just recently Israel began this campaign against Iran, taking out many of its nuclear facilities.

I think you and I are both surprised that they didn't do this earlier. In your mind, I guess should one of the primary goals of Western allied powers be to stop other countries, especially poorly behaved ones, from obtaining nuclear weapons? I feel like this was sort of something that was talked a lot about North Korea for a long time, long ago, and now that ship has sailed and obviously China plays a sort of a critical role there.

But I imagine that's always been the reasoning in my mind why there's this ultimate danger of Iran obtaining nuclear weapons. Something that, you know, they were doing, you know, spinning centrifuges, you know, attempting to do for a long time, all these sort of failed attempts at various deals and so forth.

I'm curious what you think about that. And also just really the changing role or relationship between the US and various countries in the Middle East. The sort of warmth, I guess, in the US relations with UAE and Saudi, I think. Something that kind of almost wasn't even necessarily imaginable 20 years ago.

And certainly Israel making friends with the Sunni nations as well, trying to find partners that are also sort of allied against Iran as well. I'm curious what you think about. The Middle east has kind of evolved and the US's role in that. And obviously there's an economic component of that as well.

You know, Saudi, Saudi Aramco having an IPO, there's the UAE is trying to attract a lot of investment. They've developed common law courts, you know, and basically imported Western judges from Hong Kong and Australia and elsewhere because they want business courts, because they want to do business like the rest of the Western world does.

I think Saudi to some degree wants this as well. I'm curious how in your mind the Middle east is, is, is being transformed in that sense too.

Kyle Bass: Yeah, I think. That's a great question. Look, we made a, the Biden administration made a, a huge blunder with the turning our back on Saudi Arabia and embracing Iran.

I mean that was one of the craziest policy moves I've ever seen, right? Whether it was Jamal Khashoggi and the botched, call it kidnapping, which turned into a murder by the Saudis. You know, look, no, no, sovereign's perfect. I don't think they set out to kill him. I think he got over sedated and died.

But that is also not one, one life is not the reason to turn your back on your number one ally in the region. And so Saudi has been aligned with us for a very long time and they are our principal ally over there. And now the UAE as you know, had embraced China.

They were dancing both sides like the Qataris were, or are. And as of Q1 of 2024, you saw the UAE decide to align themselves with the US and walk away from China. And you can look back to Sheikh Tahnoun, who's MBZ's brother and he's in charge of all the sovereign wealth and all the AI and hit their AI conglomerate G42.

And they said, you know what, we're just going to rip Huawei out and we're going to go with America on this one. Hopefully we see that follow through in the UAE. So imagine if we have our allies in the UAE who as you said, are Westernizing to the extent that they can.

They have a, they do have a very religious community. So does Saudi. And the strange bedfellows with the Abraham Accords, you know, the Jews and the Arabs getting together, the Jews and the Sunnis coming together for these accords. That's a very positive development in the Middle East, let's hope it continues.

Of course, Iran and their proxies, they don't want the Abrahamic courts. My view on October 7th is that was to disrupt the Abraham Accords from moving forward. I still think the Abraham Accords will move forward. But you have a scenario where poor, you said poor nations, but poor crazy, rogue, insane nations should certainly not have nuclear weapons.

You know how we contain rocket man, Kim Jong Un? I, I'm not sure. I think China contains him. You know, he's like, he's like a, a rabid rottweiler in a cage, right. They just kind of feed him every now and then and keep him hungry. And, and so as we move forward, now that Israel has, has acted on Iran's nuclear capabilities, I think the Middle east can be a much better place.

That is all with the caveat though of saying the world's architecture of the financial system is broken. And especially in many of those Middle Eastern nations. The world's priced in dollars, John. We just pushed 50% dollar inflation to the world in a four year period and they have a negative convexity to us.

They meaning any country that's not self sustaining. So I don't think there's going to be any detent or any denouement anytime soon. I think that things are going to escalate before they deescalate and unfortunately I just think there's a lot more kinetic conflict coming because of the architecture of the world being broken.

But in the Middle east, focusing on our relationship with the UAE, our relationship with Saudi is a very, very good thing in my opinion.

Jon Hartley: I just want to close, I guess one last question on sort of legacy and investing, long term investing. And I think for a long time we think the US has been sort of the only game in town.

If you just look at sort of world equity markets, the US is the one place that continues to really just crush it. And a lot of this has to do with the tech sector, A lot of it now has to do with AI. But you have these major tech companies that just don't exist in Europe or Canada or Japan.

And it's a big part of why GDP per capita and the US keeps growing while it remains flat in the rest of the Western world in Japan. And you know, for many years, you know, you were on the board of directors of the University of Texas and Texas A&M investment management company UTIMCO.

Endowments have very long horizons. I'm just curious like what your thoughts are and what you would tell sort of endowments and very long-term investors? Are you sort of in from sort of a global macro perspective in your mind, is the US still the only game in town in terms of long run, very positive expected returns, the place where innovation happens for the foreseeable future?

Or do you see other countries starting to participate with this more in the future? Obviously the EU I think steps on its own toes with a lot of this tech regulation, making it very difficult for tech companies to exist there. But I think if you were to strip out all these tech companies from the us, the US would probably look pretty much like the rest of the West.

But that's the one thing that I think makes the US economy so unique. I'm curious what you think about the US as a long-term asset class in general on the equity side of things?

Kyle Bass: You've set it up perfectly. My short answer is yes. I think the US is the best place for your capital allocation.

We are 4% of the world's population. We're 26% of the world's GDP. We are 60% of the world's capital markets, so why? Because people vote with their money. We have the most liquid, best, deepest capital markets in the world. We have American exceptionalism in our schooling and in our entrepreneurship.

To your point on Europe with GDPR and some of the foot their own goals that Europe scores on themselves, you know, and then they continue to like double down on the instant replay after they just watch the bad movie. You know, like after they see the play and they know how it's going to play out, they just do more of it.

It makes no sense at all to me what Europe's doing. And then, you know, we are the place to be. I have looked and studied the history of the world and I can't find an economy that was bigger than 26% of the world economy. Maybe there was one in the past, it just wasn't recorded properly.

But we, we are still the best economy in the world with the best prospects, with the best system. Now we have our, we have our challenges and the frictions are growing and that that gap between the wealthy, the middle class and the poor continues to grow because we're going to keep running $1.8 trillion deficits going forward.

So that's the caveat, Jon. But if you're investing your money, I can't imagine anywhere better than the US to invest. And I'll give you one last thought here. If, if I told you as a very smart young economist and I said, Jon, I know today I have a crystal ball 20 years from today, I know of an economy that will grow its GDP 500% over 20 years and they will become the world's second largest economy.

And they have a public index. How much of your money would you put in that index? You'd say, well, I don't want to put words in your mouth, but would you say, I'll invest some in that index?

Jon Hartley: Absolutely.

Kyle Bass: So if you invested in the Shenzhen Shanghai 20 years ago and China has reportedly grown their GDP now 505%, it's actually 18 years ago.

Let's just go 18. You've lost a third of your money and they've grown their economy 505%. What else do you need to know? You're the patsy. The Westerner is not going to make the money. The Westerner is going to get left holding the bag in a communistic economy.

Now, could you have traded and made money along the way? Of course you could. But I'm not interested in picking up dimes in front of bulldozers. I'm interested in making longer term investments in companies that we know can succeed. And the US is always going to be that place.

Europe again. If you parachuted a capable person into managing the EU, you would get rid of GDPR, you would encourage entrepreneurship, you would give tax incentives to move companies over there and you could revive Europe. If you think about the architecture, you mentioned Milton Friedman and you know what he said right before he passed away?

When the world hits a speed bump, it's going to kill Europe because they don't have a real union. They have, think about this. They still have, they have no fiscal union, they have no central taxing authority. They have, they don't have a unified fighting force. There's still a French navy, there's still a German army, there's still a Spanish air force, and there's no deposit guarantee scheme across Europe.

Europe's not actually a union, it's just an idea. And so if I'm thinking about investing capital, are there some interesting European companies here and there Maybe. Mean they make great leather goods, right. LMDH is worth a trillion bucks. But you know, branded luxury is what Europe's good at.

Europe is a retirement community for the world. It's where the world's rich go to hang out because it's beautiful and has a lot of history. But the US is the place where all of the growth is going to be and it's where all the other innovation is.

Jon Hartley: Absolutely and it's amazing too when you think about over time, all these forecast premonitions, you know, the, the all these people that have predicted that, you know, the USSR was going to eclipse the US in growth, and then it was Japan in the 1980s and then China in the 2000s.

And it's amazing how all those predictions have failed. Paul Samuelson famously had, I think it was in his 1960s textbook that the USSR would eventually eclipse the US and, yeah, all those predictions have failed. So it's amazing how it's such a terrible strategy to bet against the US in many ways.

Kyle, I really want to thank you for coming on. This has been a really amazing conversation.

Kyle Bass: It's a pleasure, thanks, Jon.

Jon Hartley: This is the Capitalism and Freedom the 21st Century podcast, an official podcast of the Hoover Economic Policy Working Group, where we talk about economics, markets and public policy.

I'm Jon Hartley, your host, thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Randy, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Jon Hartley your host. Today my guest is Randy Quarles, who is an attorney and investor. He served as Vice Chair of the Federal Reserve for Supervision, is Chair of the Financial Stability Board, Undersecretary of the Treasury for Domestic Finance in the George W. Bush Administration and is currently the chairman and co-founder of the Cynosure Group, a Utah based investment firm. Welcome, Randy.

Randal Quarles: Thanks for having me.

Jon Hartley: Well, Randy, I'm super excited to talk to you about all things FinReg or financial regulation wise, but I want to start with talking about your early life.

You were born in San Francisco, but raised in Utah and studied at Columbia for your undergrad, you did your law degree at Yale Law School---never heard of that place. You worked at Davis Polk, you worked for Nick Brady in the George H.W. Bush administration, you later worked at Carlyle. You know, interestingly, many of those places are some of the same places that Jay Powell worked as well. I'm curious, at what point did you get interested in financial regulation? Was this something very early on for you or was it something that you sort of grew to enjoy over time?

I also know as another fun fact I think you were at, when you were at Yale Law School, you were part of one of the, I think you were part of the founding chapter the Federalist Society at Yale Law School there. I'm just curious, like at what point did you really get into financial regulation?

Randal Quarles: Well, it wasn't in law school. I had a law school classmate who from the day he walked into school, very, very good friend who very much, you know, was focused on financial regulation, international banks. He knew exactly what he wanted to do. And, and I did not. I probably wanted to be more of a constitutional lawyer and a legal academic.

I became a little disillusioned with the academy during my time at Yale Law School and much more interested in the sort of practical application of law and policy went to Davis Polk. Davis Polk is one of the main, I guess you'd say the two main financial law firms in the country, along with Sullivan and Cromwell. And so that then became my exposure to the technical aspects of financial regulation, both bank regulation and regulation of the financial system more generally. And I found it very interesting and it was my job. And after several years there, the, you know, the treasury, this is now at the very outset of the George H.W. Bush administration. The Treasury had taken on, in the aftermath of the Savings and Loan Crisis, a study of financial regulation, the Glass-Steagall Act. They asked sort of the usual suspect law firms in New York, there were four or five of them to nominate a candidate to come down and join the team that would be working on that project.

Along with Bob Glauber, who was an academic from Harvard, Jay Powell, who by that point had left Davis Polk and was a investment banker at Dillon Read, which had been Nick Brady's firm, John Dugan, who was a lawyer, who'd been the general counsel of the Senate Banking Committee. And they wanted someone about a sixth year associate in seniority, which is where I was at the time, to come down and kind of be the junior person on that team to bring the sort of technical expertise. Davis Polk nominated me. I went down and joined that team. And you know, so it, it was serendipitous as opposed to a result of a long-standing strategy. But you know, with hindsight kind of inevitable given the places that I went and the people that I worked with.

Jon Hartley: Fascinating. I know Bob Glauber, he was one of my own professors at the Harvard Kennedy School and I knew him before he passed. Amazing you worked with Nick Brady and in all these amazing figures like Jay Powell.

I want to talk about the financial crisis, I think the financial crisis was a defining moment for financial regulation. I mean, what went wrong in the Global Financial Crisis 2008? As you see it, in terms of sort of underlying causes, what went wrong with banks? Would lack of bank capital be at the top of your list? I know other folks like to talk about contagion a lot. I'm curious, how do you diagnose the global financial crisis and what was wrong with banks?

Randal Quarles: Capital was obviously relevant, but I wouldn't put it at the top of the list as the cause of the crisis. I think. I mean this sounds quite mundane, but I think the financial crisis was almost an inevitable, certainly an expectable consequence of the combination of human nature and the Great Moderation.

So you know, when I started out as a very young lawyer back in the Coolidge Administration, you know, the practices of banks making loans were, you know, extremely tight. They were very buttoned up. And the express job of the young lawyers was to keep the young bankers in line.

The bankers were the clients, they knew the deal. But you were to ensure that all of the due diligence was done. That all the things that might go wrong had been thought of, that the appropriate measures had been taken to protect against what might go wrong.

And at the very top of the systems, at both the banks and the law firms, the, you know, there were very clear instructions to the troops down below that this is how it was supposed to go. And people were very careful. And over the ensuing 30 years from, you know, from when I began, the, the people became laxer and laxer because nothing very bad happened.

Those practices had developed because some bad things had happened in the 60s and 70s with respect to the extension of credit. And you had the sovereign debt crisis of the 80s, but you didn't have systemic results as a consequence of that. You had the 1987 market crash and which seemed to happen and be extraordinarily dramatic, as I recall at the time and yet nothing really bad happened.

And I think you can, yeah.

Jon Hartley: In the real economy at least, nothing I guess.

Randal Quarles: Exactly. In the real economy.

Jon Hartley: All these Latin American financial crises going on in the 80s too, and their inflations and so forth.

Randal Quarles: Exactly. But, but with respect to the, with respect to the advanced financial economies and the, you know, and sort of credit, you know, widespread credit problems as a result of what was the, you know, of some of these quite significant events, it led to, again, just this is, I think, almost inevitably human nature, it led to a well, we don't have to be quite as strict as we have been in the past with respect to the practical measures that we take in connection with the extension of credit. We can get more creative with the vehicles and mechanisms through which we extend credit.

We can increase the amount of leverage. And if we don't, somebody else will. And so within organizations, the inevitable pressure again from the folks who are doing the work to the folks at the top who used to say, you know, let's keep this all together. You know, kind of like raising teenagers, after a while you just say, this is exhausting to listen to you complain, yeah, go ahead and do it. And which ultimately led to a situation where you had, you know, a lot of poorly structured, poorly underwritten credit in what extended in ways that were not always obvious that it had even been extended, and certainly what the amounts were. And I don't think that was a result of bad bank regulation or bad bank supervision or, you know, I'm not even sure that you would call it bad management of the institutions.

And certainly not people were neither crooks nor idiots involved with that process. You know, they were human beings who had lived through an extraordinary stretch of quite good times. And that's what's going to happen now. You know, when the, you know, when the crisis happened, it became clear that, we should have tried to ensure, since we can't, since we are human and can't really feel that that's happening over the course of decades, can't see where, you know, where a big financial stability shock may be coming from.

We should have a system that's more resilient to shocks. We should have more capital. But it wasn't really the regulation or the capital levels that were in any way a cause of what happened.

Jon Hartley: Sure, well, I guess, yeah, had the capital been different, I guess, would it have been a different result.

There's all sorts of, I guess, people who, I guess there's different sort of schools of thought. There's some, I guess, who would say that one. I mean, there was obviously a big buildup in housing and, you know, to what degree that was even preventable, I think, is another question.

Whether this lacks lending standards is it something that was a cultural issue versus, I guess, a regulatory issue. Then some people point to the Community Reinvestment Act (CRA) as incentivizing housing in some way, sort of passed in the 90s. And I guess then there's other people who sort of blame mass securitization, CDO squared, as creating too much sort of complexity and financial markets and that sort of complexity.

Randal Quarles: I really think that all of those are various manifestations. Really almost all of those are various manifestations of the larger kind of the larger theme that, you know, the caution that was drilled into people involved in the extension of credit in its various forms, you know, in the late 70s and early 80s as I was starting, my career, eroded and it eroded because we were living through a pretty good time.

And I'm not sure. And, and that will happen again in part because measures that were taken in response to that have again allowed us to live through some pretty good times, some at least with respect to the stability of the financial system. And over the course of a long period of time, humans will be humans.

You're not going to change that. And they will get complacent.

Jon Hartley: Well, I guess so. I guess moving away from some of the causes, you know, crises are, are a fact of, of life and they aren't, you know, recessions, I don't think they are ultimately preventable. I mean, there are these disasters that just happen often, almost always for unforeseeable reasons.

But I guess so fast forward, 2008, Bear Stearns, there's all these problems that emerge with Bear Stearns and later Lehman. Then you sort of, you have September 2008, you have these sort of panic moments where, you know, first Fannie and Freddie are put under conservatorship. So you have that, then you have Lehman, you know, Lehman, you know, declaring bankruptcy.

I think Hank Paulson was looking for a buyer for one many of these, you know, JP Morgan came in and bought Bear Stearns, you know, Merrill Lynch was bought by Bank of America. You had these big commercial banks kind of bringing stability in buying up these distressed investment banks.

In some cases, there was help from, from the, the federal government, from the Federal Reserve to, to make those acquisitions. And then there was sort of this Lehman moment where there was a question of, you know, what to do with Lehman. And my understanding from, from Hank Paulson, then Treasury Secretary, was that he was trying to find a buyer for Lehman with Barclays.

And they were halted by, I think, the UK government. There's something that, I think, Paulson is sort of blamed at least in terms of the Lehman bankruptcy. But I guess, you know, in your mind, would things have been very different had Lehman actually been sort of outright saved in, in some way that the government, I guess, tried to completely backstop in some way rather than letting it go?

I mean, in your mind, could things have been played out very differently had Lehman not sort of gone bankrupt the way it did?

Randal Quarles: No, I actually don't think things would have been that different if they had somehow bailed out Lehman. I may be one of the five people who still believed that was the correct decision.

And if you go back and you look at how the financial crisis evolved on kind of a day to day basis during that time, you had the Lehman failure. And if Lehman is going to be the cause of a crisis of confidence in the system, you can't really see that in the performance of the financial system in the immediate aftermath of the Lehman crisis, in the performance of credit, in the performance of various markets.

The actual crisis began almost a couple of weeks later, maybe not quite a couple of weeks later. In my view, the trigger was the failure of WaMu and most specifically the manner in which the failure of WaMu was handled. And I'm not. And because again, markets were, you know, obviously they were under strain because of everything that had been happening over the course of the summer.

But in the aftermath of the Lehman crisis, they were not particularly more dramatically affected until the failure of WaMu. At Carlyle, for example, we were in the process, for example, of considering kind of a anchor, confidence inspiring investment in Wachovia. Bob Steel, who had succeeded me as Undersecretary of the Treasury, was the CEO of Wachovia at the time.

And the thought was Carlyle, a private equity firm, even the size of Carlyle is not going to be able to. Put in enough capital to sort of fundamentally recapitalize Wachovia, but that if we would make a significant investment, having done a lot of due diligence on the state of the bank, that that would anchor confidence and would, you know, and would shore up others in being willing to provide various sorts of financing to the bank and settle its situation.

And we were prepared to do that up until the failure of WaMu. And, and the FDIC was worried that there could be a number of bank failures that it was facing going forward, given the stress that the situation saw. And so they wanted to preserve the fund. Therefore there were categories of obligations of WaMu that were, had traditionally been protected by the FDIC in a bank resolution, although they weren't legally required to be that in this case, the FDIC said, well since we think we need to really work to preserve our fund, we're not going to preserve them.

But there was little advance warning of that with the failure of WaMu and little and confused communication around it. And that is when you saw kind of the system of financing for banks completely freeze up. Everyone said, well, wait a minute. We now don't know what the rules are. We don't know what's going to happen in the event of a bank failure if we extend credit. And that's, in many ways it's not surprising. It's almost economic law that uncertainty and unclarity is, you know, perhaps the worst villain in sapping confidence in a system. It's like, if I don't know what's going to happen.

And so we immediately stepped back from providing the equity investment in Wachovia. We said, we don't know what the rules are anymore. And Wachovia failed relatively promptly after that because. Because it was now part of the system being swamped by a lot of providers of financing to the banks and to the financial system generally, saying, we don't know what the rules are.

And in my view, it's an eccentric view, I allow, but in my view, that was the trigger of the financial crisis. It was not Lehman. And I think, you know, going forward, letting Lehman fail was the right thing. It's the moral hazard question that people were concerned about.

The moral hazard reason that they did not save Lehman. The view that going forward, you want people to say they don't save everybody. As we're making decisions about what sorts of risk we ought to be taking, we can't count on being bailed out. And I continue to think that that was the right decision.

And that it was not a trigger of the crisis.

Jon Hartley: Got it, but you don't think I guess in my mind one seminal moment was this fact that, in my mind there's a clearly a run on money market funds. Particular prime funds, and the reserve fund, the oldest money market fund in the US broke the buck.

And I think a big part of that run on money market funds, again it's an untraditional sort of bank run. It's not a traditional people lining up to get their deposits out of a commercial bank, but essentially money market investors trying to get their money out of money market funds was that there was this Lehman paper that exists, a commercial paper, and people were freaking out about that and that. But that wasn't in your mind that the money market run that kind of existed was not sort of the trigger in your mind?

Randal Quarles: No, I don't think so. Not as important, not the proximate cause. All of this added up to create an environment in which the financial crisis could happen.

If that environment hadn't been building, you could have had a failure even of an institution as large as WaMu without a financial crisis. We just had Silicon Valley Bank fail a few years ago, which was not quite as big as WaMu, but along the same size.

And it didn't trigger anything like that. So, part of that was the extra amount of capital in the system, but part of it was just, you know, you didn't have these other elements but, but I don't think they were nearly as important or really the triggering cause and certainly not the failure of Lehman relative to the failure of WaMu.

Jon Hartley: So another thing that I think comes up in these sorts of global financial crisis diagnoses is in this question, the big banks and Senator Warren I think often, and others often said, well, all the Gramm-Leach-Bliley big bank consolidation in the 90s that was allowed to happen was part of this cause and which break up the big banks.

And, and I mean to me that seems like not a great sort of story either or explanation either. In fact, like in my mind, I think if the big banks have been broken up, maybe the financial system would have been less stable. I mean, there's largely investment banks that were stressed during the global financial crisis.

The larger, more diversified commercial banks, the JP Morgan, Citi, Bank of America, the larger financial institutions were generally safe. And this is an argument that I've heard from Ben Bernanke, sort of against breaking up the big banks is that in diversification, having both commercial banks and investment banks under sort of one umbrella allows for better weathering of these sorts of shocks.

Do you sort of buy that line of reasoning?

Randal Quarles: Absolutely. I mean a large part of the work that I did both as a private sector lawyer and then in policy work during the course of the 90s, during the, during my time in the Bush 41 Administration was, was precisely to increase the financial resilience of the system and particularly the banking system by first, you know, we put forward a proposal for the revision of the Glass-Steagall Act.

It's actually incorrect to say that the Glass-Steagall act was repealed because the central provisions of Glass-Steagall were never repealed. There ancillary provisions that were repealed. But the revision of the Glass-Steagall act to allow the creation of kind of merchant banks to allow investment banks to merge, but the first order of business was simply to allow banks to merge across state lines, which was not possible in the early part of my career, which I guess is a long time ago now, but it's still within the mind of living memory.

And, and that was very useful when you had, you know, over the course of that period you had some intense financial problems in Texas at the beginning of that period and then you had some intense financial problems in the Southeast. And because we had changed them one of the results of the Bush 41 Administration was to ease the restrictions on interstate banking.

You now had banks, you know, North Carolina National Bank, which eventually became Bank of America, you know, had for, had required, had acquired a Texas bank. And as a result it had the resources to prevent that Texas bank from failing when there was pressure in Texas and that system had the resources to prevent the bank from failing when there was pressure in the Southeast.

And you know, so those mergers were very much. Kind of financial stability supportive, first by allowing geographic diversification and then by allowing business line diversification. And exactly as you said, if we had not modified the Glass-Steagall Act to allow Morgan Stanley and Goldman Sachs to become bank holding companies, which, before, under Glass-Steagall, they could not, in the great financial crisis, those firms would have failed.

In the great financial crisis, the first thing they did was we need to let the world know that we are supported by the Federal Reserve and the Federal Reserve's backstop. And so they immediately became bank holding companies, which they were able to do because of these changes that had allowed banks to become larger and more diversified.

I mean, it's not. There certainly are issues as any organization becomes extremely large. The largest banks now have hundreds of thousands of employees. There are management concerns, totally appropriate official sector issues in ensuring that, you know, that the management of those banks is up to the challenge of managing organizations that are that complex.

But from a pure financial stability point of view, all of that has been a positive and not a negative.

Jon Hartley: Great, so I guess sort of just moving forward in time here we had the global financial crisis. We had all the interventions, TARP, TALF, the Fed was buying up toxic assets off bank balance sheets.

The first Quantitative Easing or QE1. And then we had this thing in 2010 which was the Dodd-Frank Act. And it did a lot of things. But, but as far as bank regulation goes, some of the bigger things that happened was, you know, imposed capital standards. So there's both a risk weighted capital ratio and a risk neutral one.

The whole idea is just, you know, limiting the amount of leverage that can be taken. So for our listeners that aren't as familiar, there's sort of beyond just the US there's this idea of Basel 3 capital standards which sort of comes out of the Bank for International Settlements, the BIS in Basel, Switzerland.

And they sort of put forth these capital standard ideas that have been implemented across various countries. And Dodd-Frank was the US manifestation of that. And so there'd be risk weighted capital ratios or Common Equity Tier 1 (CET1) as a fraction of risk weighted assets . And the idea is that the amount of equity is a share of risk weight, assets is above a certain threshold.

And similarly your SLR or your leverage ratio, your supplementary leverage ratio, is at a certain level. And so all this is about the liability side of the balance sheet in the sense that we're setting a minimum limit for how much equity there is, which is another way of saying a maximum for how much leverage there is as a fraction of the total capital or total assets.

And so, there's a risk-weighted way of looking at this, anonymous-weighted way or a risk-neutral way of looking at this. Now, sort of fast forward many years later, something like SLR might be binding. For this is the sort of risk neutral ratio, you might be buying for a bank like Goldman Sachs, which does a lot of treasury market making. The risk weighted capital ratio might be buying for a bank like Capital One that does a lot of risky credit card lending.

Credit cards sort of get this high risk weight of one. So I guess my question for you is, is the financial system today, you know, safer after Basel III. Is the global financial system safer in, in your mind, or are the banks too regulated or not regulated enough?

Randal Quarles: Well, I think it's unquestionable that the system is safer. The increased capital levels, the Basel capital price process, beginning all the way back to Basel I in the 80s, has been run at the significant insistence or impetus from the United States to try to ensure that the competitive environment for international banking was such that our banks could compete without being pushed to lower their capital to dangerous levels.

So in the 80s, the Japanese banks operated with very little capital, certainly relative to ours and relative even to the Europeans. And Basel 1 was an effort to get international agreement that that capital needed to be increased. And then, you know, over the course of the 90s, it became clear that the European capital levels were lower than those in the United States.

Our internationally active banks were being disadvantaged. And so, you know, Basel 2, which is, you know, was really kind of an incredibly complicated, very analytically granular, intelligent, ultimately I think, misguided approach to try to create a framework in which we in the United States could be comfortable and confident in allowing our bank's capital levels to lower themselves to those of the Europeans by creating, you know, sort of an agreed and careful risk assessment framework.

It was very complex, probably excessively complex, but no sooner had that been completed than we had the great financial crisis and we realized that that was the wrong direction. We shouldn't be lowering our capital levels to match the Europeans. We should be raising the Europeans capital levels as well as our capital levels to higher standards.

And that was the point of Basel 3. I think that, you know, conceptually it was successful. You know, it has been successful. I think we've seen the increased resilience of the banking system to some shocks like those that happened in the spring of 2023 and you know, so unquestionably the system is safer.

Are banks too regulated? Well, just to take the capital system, the capital framework as an example, it is excessively complicated. We have now a very complicated set of through-the-cycle capital rules in the aftermath of Dodd-Frank and through Basel 3, we've layered on top of that a stress testing regime which I think is very useful.

It's very, it's well done by the Fed, really competent people who run the process. But it is incredibly complicated on top of what is already a fairly, you know, a much more complicated kind of, of standard capital framework than it used to be. We, you know, are now regulating liquidity, which we should be, but, you know, in a much more direct way than we did before. Much more complicated way that may be getting more complicated in the aftermath of SVB. The supervisory examination of banks is much more burdensome and again, particular and covering a broader range of activities with much more direct instruction than it used to be. So all of that is, again, that's an inevitable human response.

Response to something like the great financial crisis. And I think that directionally it has made things better. You can't question that. But it's also improvable. That can be streamlined, that can be rationalized, that can be, okay, well, now we're doing the same thing in three different ways. Maybe we can do it in one and a half different ways and that will be enough.

And thinking all of that through is, I think should be inevitably the task of the bank regulators and thinking through the practices of bank supervision, the task of the bank supervisors. You know, once the, you know, the immediate reaction through Dodd-Frank and Basel 3 to the great financial crisis is in place, then you say, all right, now, now, with the benefit of experience, with the benefit of a little calmness, how do we improve that?

Jon Hartley: Got it. I've worked at Goldman Sachs and in the aftermath of the financial crisis, or in the years after in the 2010s. And yeah, I worked in risk management and kind of had a sense of how some of these worked in portfolio structure within risk management in GSAM. But I had firm-wide risk management friends that were sort of dealing with the CCAR and stress test side of things at the bank level. So I guess like one question and complaint that I've heard is that, you know, from people broadly, you know, in general in the policy space, not just any particular bank, is that, you know, the stress tests aren't transparent.

You know, there's a bunch of scenarios that are given and it's not clear ahead of time what they are and they sort of change from year to year could, you know, and some people say, you know, a lack of transparency is kind of a virtue in the sense that banks should be prepared for all sorts of scenarios. But I guess, is there some way in which that could maybe be done better? I mean, also, at the same rate, you're hearing from folks. I think this is a Jamie Dimon question, he asked how many bank regulators we actually have physically in our building any day?

And it's, you know, it's hundreds of people. And I hadn't realized myself when I was working at Goldman Sachs that there were actually, you know, Federal Reserve employees or regulator employees that were actually in the bank. Is that too many? So I guess I'm just curious what your thoughts are on just stress testing and how that process maybe could be improved, if at all, in your mind.

Randal Quarles: Yeah. So first I should say, and there are two aspects to the answer that I'll give. One is one sort of legal, constitutional, but that aspect of policy, not legal in the sense of, you know, kind of granular regulation, but. And then the other is, you know, a different set of policy considerations around the, you know, how the stress tests need to be constructed in order to be effective.

Stress testing is, is an obvious, an obvious good. It's something that bank supervisors should be doing and in, in some ways not nearly as expansive and as rigorous as has happened in the aftermath of the great financial crisis, but in some ways have, you know, been doing for a very long time.

And, and we saw a particularly important example of that during the COVID event where the rest of the world, almost all of the rest of the world, immediately upon the sort of global administrative shutdown of the economy, said, well, if businesses can't operate, they can't pay their loans, and this could be a huge problem for the banking system.

And bank regulators around the world shut down the ability of their banks to pay dividends. They simply forbade them from making any distributions at all. And we, we closed off the ability of banks to repurchase their shares, which in the US System is a significant, you know, is actually the majority of the way that that capital is returned to shareholders.

But dividends are still important, and the dividends is the only thing that's promised. Right? The share repurchases are easier to, to close off because there's no promise that that's going to happen. And because we were just in the process of completing the stress test for that year, we had confidence in the, we could add in there some additional variations to the scenarios to say, well, what if this happens?

What if that happens as a result of COVID what happens to the system? And then over the course of the succeeding 12 months, we ran seven different stress tests. It was, it was a, I mean, the, it was a great national service on the part of the stress testing staff at the Federal Reserve and just an almost impossible amount of work for a team that we weren't able to increase in size just given the speed with which all of this was happening.

And, and as a result of doing that, we maintained confidence in the resilience of our system. That allowed us to say, no, you can keep paying dividends until we see some evidence that the system is under a level of stress that it can't support, you may keep paying dividends.

The information that we have from the stress test shows that and our, the cost of capital for our banks was, you know, is now, is now much more favorable. There are many reasons for that. But this is an important reason for it than for European banks, because you're providing equity capital.

European banks, and you say when they get spooked, they could just say you can't pay. Whereas in the US they do everything they can to preserve those payments if it's going to be safe. And we had the mechanism to say it was safe through the stress testing. So all of that is great.

Now, on the question of the transparency of the stress tests, there's the legal question of these are quite consequential government actions because particularly particularly in the aftermath of a measure that I took which I thought was necessary and appropriate, again as a, just as a good government measure, that there would be predictable consequences of a certain result of the stress tests.

If your stress test shows that you need more capital, then you will be required to have a buffer added to your particular bank's capital requirements that will increase your capital by that amount according to the stress test. Before that, the results of the stress test did not have any determinate consequence.

It was all a result of what the Federal Reserve Board had for breakfast on the morning that they were presented with the results. And that's just not a way to run a railroad. But because of that change, there is a fairly direct and important economic and financial consequence for individual institutions as a result of running the stress test.

And our system of law, the Administrative Procedure Act, constitutional principles would say that can't be the result of a star chamber process. You must be transparent. People need to know if that, if something like that can happen, what they can do to prevent it from happening. And you know, the example that I would often use would be to say, yeah, if you took all the speed limit signs off the roads and said, “but there's still a speed limit, and it varies from day to day, and we're not going to tell you what it is or how it's determined, but if you exceed it, you will have a very serious fine”. Well, people would drive slower, they certainly would. But you can't do that in America. I don't think you can do it in Russia.

So there's the legal side of it, that transparency, a significant amount of transparency is important. And there are lawyers who say that the whole process, all of the models, all of the scenarios need to be totally public and subject to comment on. On making sure that the stress tests are fit for purpose, however, I was persuaded in my time at the Fed and remain persuaded of the so called monomodel argument that's going to be very familiar to many of the folks who listen to your podcast, that if the Fed is totally transparent about its framework for assessing the resilience of any particular bank's portfolio of assets, then whatever mistakes and eccentricities and idiosyncrasies that there are in that framework, and those are inevitable, then all of the system will congregate around those and those now become the fault lines of the system where there will certainly be breaks going forward.

And to the extent that you are not wholly transparent, you at least ameliorate, you can't eliminate, but you ameliorate the monomodel problem. I think that's real. I think that's, and to ensure that the stress tests are actually fit for purpose, I think it has to be taken into account. I tried while I was at the Fed, you know, for a balance that maybe was not the most ineluctably principled, but I thought practical of we can be more transparent, we can be much more transparent about what it is, what the models show without completely opening the kimono towards the monomodel problem.

And the staff was making, I think, material progress in being more transparent around the models. I think that stopped pretty quickly after I left and I think it should be picked back up again. So that's, that's probably a lot more logaria around your simple question of, you know, should the stress test be more transparent?

I think the answer is they can and should be, probably are required to be under law, but we shouldn't completely open the kimono in the way that some would ask, because then the stress test would not only not be as useful, they could even be counterproductive.

Jon Hartley: Got it, and I guess, yeah, one criticism, I guess it could be gamed in some way. If it was totally---

Randal Quarles: I think you could say, yeah, I was always less worried about the gaming argument. People would say, if you, if you give them the models, you're, you're showing them the answers to the test, it's like, no, you're giving them the textbook, you know, and, and it would not be right to give a test.

You know, it's not right to give a test that you've given the answers away to, but it's also not right to give a test that you haven't given anybody a textbook for.

Jon Hartley: Absolutely. That's a great way of putting it. I just want to fast forward a little bit here just in time to your time at the Federal Reserve.

You were nominated during the first Trump administration to be the first vice chair of the Federal Reserve for supervision. And then you are also the chair of the Financial Stability Board from 2018 to 2021. I'm just curious in your mind and just, I guess for some context, too, around that time, in terms of what was going on in FinReg, there was the Jim Hensarling Bill that changed the SIFI threshold and increased that. So there was kind of that going on in the backdrop as well and the SIFI threshold is basically a certain threshold above which you're treated very differently in terms of regulation, having to do these sorts of, this regulatory scrutiny from the perspective of regulators. And I think when it was increased, it affected banks like SunTrust and BB&T at the time. They've actually since merged. That's a whole other story. But I'm curious, what, in your mind, were your greatest accomplishments during your time at the Fed Board and as Chair of the Financial Stability Board?

Randal Quarles: So at the Fed, you know, I think you, I think I would say it was the, it was the whole complex of refining and revisiting and streamlining the post financial crisis regulatory framework.

The principal element of that was the mellifluously named EGRRCPA legislation that we then implemented. We worked, you know, we worked very closely with the Senate and the Congress in, in developing that regulation and then, and then through the implementation process. But there were, you know, I think there were over 20 separate measures that we took.

And I was, you know, I came in saying there were lots of folks, you know, who kind of wear my political jersey, lots of people who think about the industry who said, you know, Dodd Frank was an unmitigated disaster, you need to strap a napalm tank onto your back and just burn it all to the ground.

And my tac was to say, look, no, what we're going to do is we're going to identify some material things that will make a difference. You know, the overall benefit of the increase in capital from Dodd-Frank is that that is a good thing. But we can increase the efficiency of the system, which is a public good that is probably equal to the safety of the system.

We can increase the efficiency of the system in ways that do not harm its safety. And we can do that in a way that we're very methodical about, that we make a very good case for, and that we get enough bipartisan political support for that. When we're done, the next folks will come in and the pendulum won't swing back because the case will have been made and we will have been meticulous enough about what it is that we that we did and why we did it and how we did it.

And I do think, you know, at first, you know, when, when my successor came in, who is a smart and good guy, but have very different views than mine, and some of the initial proposals, people said, we told you so, you know, that was a bad strategy. It's a one way ratchet.

You came in and you said instead of burning it all down, if we burn it all down, they'll just put it back in worse. And now they're putting it back in worse anyway. But at the end of the day, that didn't work. That didn't happen. And I think one of the reasons it didn't was the way that we constructed our approach.

So I think that was at the Fed, the most consequential, and at the FSB, I think the work that we began on non-bank financial intermediation, which had really stalled in the FSB for a long time for a whole variety of reasons. You know, the FSB had done really good work on bank regulation along with the Basel Committee.

NBFI, you know, had really languished. And, and, and it, it requires a much different approach than bank regulation. And so there are reasons that that's a difficult thing to do. But we began a process by creating a separate committee where there was much more representation of the non-bank regulators relative to the central banks.

It was a little more equal than in the FSB as a whole. And that allowed progress to be made there. That again, I think was quite useful.

Jon Hartley: Great, I guess, sort of shifting just for a second away from FinReg and financial regulation. You were also, you know, by virtue of being on the Federal Reserve Board, you were also a voting FOMC member.

And you know, during this time we had everything from, during the time you were in office, everything from COVID to the beginning of the early 2020s inflation. I'm curious, in your mind, did the Fed respond, I guess appropriately both to Covid and did it respond quickly enough to inflation in terms of raising rates?

I know you've spoken on another podcast before maybe saying that the Fed should have raised rates earlier. Just thinking that it became clear that it wasn't just a transitory story by say October of 2021, in that this was around the time that you were leaving, but by that point when inflation first ticked up in April 2021, but by October it was clear that it wasn't just used cars anymore, and it was not just used car prices, but housing rental prices were going up, owner occupied rents were going up.

It was clearly broad based at that point in time. You kind of had left just at that, I think point in time when that became apparent. But in your mind was the Fed and your colleagues, were maybe they a little too slow to raise rates and maybe inflation wouldn't have been as high if they had done something differently.

I'm curious about what your sort of retrospective take is on the Fed's performance during, during that period.

Randal Quarles: Yeah, I don't, I don't think that there, I don't think the, that the Fed is guilty of any serious sin with respect to the timing of its response. I think with the benefit of hindsight, and there were a few of us, you know, even during, at the, who were there at the time who would have said yes, the time to start raising rates was in the fall of 2021, you know, over the summer.

You know, as you said, I think the data that we were seeing really supported the case that this was a supply constraint driven inflation, which is not something that a central bank can effectively respond to, and that it was a temporary supply constraint. You know, we can't unload, we can't unload containers on the ports and we can't make vaccines or anything like that.

So, but that this would in fact be transitory. The data really supported that over the course of the summer. But by the fall it was clear that, no, this is really a much more traditional fiscal stimulus driven inflation, which is something that we can respond to. Some people, Larry Summers, for example, have blamed the framework that the Fed, the monetary policy framework that the Fed put into place in August of 2020 as kind of the culprit in the Fed not responding as soon as it became clear that this was the sort of inflation that its tools were designed to address.

That I don't think is correct. Really. There probably was a majority on the FOMC in favor of saying, okay, well now we need to respond to this in September, October of 2021. And, and some were more vocal about it. Chris Waller, certainly I was supporting, there were others.

But we were still purchasing $120 billion of, you know, treasury and agency securities a month at that time. And some general principles that the Fed operated under that I think with hindsight ought to be more flexible where, well, you can't push on the gas and the brake pedal at the same time.

So we can't be continuing to purchase this amount of securities and providing accommodation in that way as we're raising interest rates. You know, that results in a mismatch. So we have to stop the securities purchases. But the taper tantrum of 2013 had taught everyone that, well, you can't stop security purchases on a dime because the markets lose their minds.

And so first you have to talk about talking about it and then you have to talk about it and then you have to have a serious discussion about it at the FOMC and then you have to announce that you're going to do it in a while. So that plan was worked out in the fall that we would go through this whole tapering process of purchases and then start raising interest rates in response to the inflation.

And it just quickly became clear that, we need to accelerate the, you know, the tapering faster than was originally envisioned. I mean, the original plan was that it might have taken as much as a year. And I think with the benefit of hindsight, the Fed will have learned the lesson that there are circumstances in which it is perfectly okay to start raising interest rates even as you're being gradual in tapering asset purchases.

And this was one of them.

Jon Hartley: Fascinating, shifting back to banks and financial regulation. I just really want to, in my last question for you is really just on deposit insurance because I think the most recent banking crisis that we've seen was really the Silicon Valley banking crisis in regional or regional banking crisis of 2023.

And we had these banks in particular Silicon Valley Bank, a large bank, a lot of insured deposit, uninsured deposits that really forgot how to manage interest rate risk. And that concern around taking losses triggered this massive bank run essentially through people's cell phones. We've never really seen a bank run quite like this before.

Typically we're used to thinking of people lining up in a wonderful life or these other famous photos of people lined up outside of banks when they get their money, to get their deposits. But here, you know, now people with a click, you know, can take, pull their money out of a bank and cause a bank run overnight.

The FDIC came in though and resolved these banks and you know, took them into, took them over and functions the FDIC should, but. And there's not just Silicon Valley Bank, there are a few others. It's also sort of led to Credit Suisse also eventually being very distressed and got bought out by UBS.

But I think there's sort of this unresolved question of what is going on with deposit insurance in that previously the rule still is on the books. Everyone has $250,000 of deposit insurance at each bank. And you could go to each bank and get another for every account, get $250,000 of deposit insurance, and you could go to hundreds of banks in theory.

But I'm curious, you know, at some level, we kind of had this de facto sort of unlimited amount of deposit insurance. I'm curious where you think, sort of, as a policymaker, where we're at and how we should be thinking about the regional banking crisis of 2023 and what we should be doing about deposit insurance from a policy perspective.

Randal Quarles: So I do buy in, you know, at maybe an 85% level to the view that the liquidity need for the current banking system, and particularly for sort of banks of, of Silicon Valley Bank’s size, regional banks and, and smaller, is durably different than it was 15 years ago as a result of advances in communications technology and in bank technology exactly as you described it.

So that the ability of a run to form and to be severe is much greater than it was. I mean, just referring back to the WaMu example, you know, WaMu failed because it was losing $1.6 billion a day, I think, and it did that for 10 days in a row. And that was viewed as an unsustainable, you know, a completely unsustainable deposit outflow. It was slightly larger than Silicon Valley Bank. Silicon Valley Bank lost $40 billion in an afternoon, and $100 billion was lined up to be going out the next morning. This is a, and WaMu was the largest and most severe bank failure in American history up to that point.

Something was different, and I don't think that it was purely idiosyncratic to Silicon Valley Bank, although we all know what its idiosyncrasies were, that made that a particularly severe case. So I do think that the liquidity need of the system is greater than it was. There are two ways, two principal ways to address that systemically as opposed to through draconian supervisory measures.

One is to increase deposit insurance and therefore to increase the amount of comfort that I don't have to go for a run on the bank because my deposit is protected and to cover a much higher percentage, if not all of the sorts of business deposits that were, you know, that were the lifeblood of Silicon Valley Bank. The other, which I think is the preferable approach because there are significant, obvious moral hazard concerns with excessive deposit insurance, is for the Federal Reserve to return to its role as the liquidity provider to the system in the. One of the mistakes, I believe, that was made in the aftermath of the great financial crisis and the focus on the liquidity position of banks, you know, the, the increased focus on the liquidity position of banks was, and the Fed has been the most extreme about this, is for the banks to self insure their own liquidity.

Basically to say you must have enough liquidity in your institution to withstand a very severe run. And, and we're going to measure that in a variety of ways with liquidity stress tests. And a large part of this has to be intraday liquidity. And that was an issue even when we were talking about a liquidity need that was of the sort that we still thought we were talking about at the time of the Dodd-Frank Act and Basel III.

If we're talking about a liquidity need where a $220 billion able to support the outflow of $140 billion over the course of 24 hours, that is, that's unsustainable that, that you can't, you can't remain a bank and have that many liquid assets inside of your system and self insure yourself.

And the Fed has been quite insistent on that. For example, when, when the Fed goes in to do a supervisory assessment of the bank's liquidity, it doesn't allow it to take into account that it has the right to borrow from the Fed. And as a consequence, many banks do not prepare themselves to borrow from the Fed.

We all know the famous story that well, Silicon Valley Bank didn't have any collateral at the Fed in order to borrow because why should it? The Fed had said, you have to have, you know, we're only counting the liquidity that you keep on your books. So it borrowed from the Federal Home Loan bank of San Francisco in order to fund putting liquid assets on its books that it could show the Fed that I have enough HQLA.

So. I think the Federal Reserve should go back to the fundamental reason that it was created. It's the reason we don't call it the Central Bank of the United States, but call it the Federal Reserve, which is that it exists to pool the reserves of the banking system and direct them to where they are most needed at any point in the event of a run.

And you know, Silicon Valley Bank, the structure of its portfolio was such that if it could have held those assets to maturity, it was perfectly solvent. It could not hold on to maturity during a run but the Fed could hold those assets to maturity. The Fed could have very safely simply lent the money to Silicon Valley Bank to pay off those deposits.

And eventually what would happen with every run is, I'm going to get my money I don't have to run. But you would do that through the Fed's provision of liquidity as opposed to kind of non discriminant deposit insurance which allows for kind of much more intelligent decisions to be made about the ultimate viability of an institution that the liquidity is being provided to and therefore an amelioration of the moral hazard problem of any sort of government intervention.

So, so, so that's again that's my logaric answer to the deposit insurance question, which is I don't think we should be increasing deposit insurance, but the Fed really needs to kind of go back to basics in thinking about its role as the lender of last resort and reinvigorate it to what it was originally intended to be.

Jon Hartley: That's great. One last question. Any last. Any thoughts at all on stablecoin regulation? There's some legislation that's going through Congress right now. There's been I think a lengthy debate about this. You know, how much should stablecoins be treated like banks and so forth and what should the sort of guide rails be?

And we've had sort of circle which runs USDC led by Heath Harper, mutual friend of ours, that this much I think been historically wanting to be regulated. Tether on the other side that's been a bit more controversial, doesn't kind of quite want to be regulated, hasn't been quite as transparent as some people would like in terms of where it's keeping its proceeds, that that's backing the stablecoin.

At the end of the day, they're both investing in treasury bills and taking the, investing the float and taking this and the interest and maintaining a stable asset. But I'm curious from a regulatory perspective, how do you think about stablecoins?

Randal Quarles: Yeah, I think that, you know, I think that stablecoins distinguish them from sort of crypto 1.0, Bitcoin, Ethereum, that sort of thing which I have no problem with, but I don't think is ever going fundamentally be transformative of the payment system or the financial system.

But stablecoins could be quite important in the financial system and particularly with respect to international payments and across border payments. And, and the official sector has some legitimate issues with regard to how the pool of assets by which the stablecoins value is measured is constructed and run. I think those issues are pretty obvious.

They're well addressed in the stablecoin legislation that's passing. They've been well addressed since the President's working group with Janet Yellen as Chair of the Treasury, as chair, as Secretary of the Treasury put out at the end of 2021. You know, the, the issues are clear, the way to address them is clear.

The stablecoin industry is actually quite happy in having them addressed in the way that has been, you know, know, kind of well understood for a while. We just went through a period where that whole process was being stymied by well intentioned but aggressive regulator who wanted to be the crypto cop and didn't want a, you know, a framework that kind of put clear responsibility, you know, clearer responsibility on the bank regulators as opposed to securities regulators for the, for the stable coins themselves.

I think, you know, once we put that framework in place, which is not politically or intellectually difficult to do and so I think it will be done over the course of this year probably we have a great framework for stablecoins to grow. I think that's not only good for the financial system, I think it's good for the US dollar and I think it then prevents some of the concerns that I have about Tether.

The people will live in that framework. It is a livable framework. It is good for the public, it's good for the industry, it's good for the financial system. And the tethers of the world will kind of be relegated I believe once we get that done.

Jon Hartley: Yeah, it's fascinating.

And there's now word that the consortium banks may be starting their own stablecoin. It's gonna be very interesting to see where the stablecoin industry goes as it sort of becomes more regulated. Randy, I really want to thank you for coming on. It's been an amazing conversation.

Randal Quarles: Thank you very much for having me. That was a great pleasure.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Ken, which is hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy. I'm Jon Hartley, your host today. My guest is Ken Rogoff, who is an economics professor at Harvard University, one of the great international economists of our time. He's also a former IMF chief economist and a chess grand master. Welcome, Ken.

Kenneth Rogoff: Thank you for having me. Jon, congratulations on the success of this podcast.

Jon Hartley: Well, it's a real honor to have you on. As someone who does international economics in my own work, it's a huge honor and just so excited to have you on and to have this conversation.

I just want to start with your early life. And I know you were born in Rochester. You're an undergrad at Yale. You're a chess prodigy and chess grandmaster. I think a lot of people know this. How did you come to find economics? Make your way to grad school doing a PhD in economics at MIT, where you studied under Rudi Dornbush.

I know your first job was at the Fed board. What was the path from there to Harvard? I'm curious. How did this sort of pivot happen from chess grandmaster to grand economist?

Kenneth Rogoff: Well, short version, I decided to go to college, which was unusual. I had more or less dropped out of high school and was living on my own in Europe.

I was doing very well as a chess player. I was rising fast. I was earning plenty of money. I actually earned more as a chess player in real terms than I did as an economist till quite a bit later in life. Although, of course, I think, as you probably know, that says something about the pay of academic economists as much as chess.

And it was much worse when I was starting out. So I just decided to go. I just decided to stop playing chess. Very unusual decision. I am still quite famous in chess for having stopped playing chess and better known for that than you might imagine. How I fell into economics was I just didn't know what I wanted to do. I don't know how to. So how did you fall into economics?

Jon Hartley: I took a high school class, and that sort of did it for me.

Kenneth Rogoff: So you were a prodigy. You. You were inspired in high school and knew you wanted to do economics and in college already when you arrived?

Jon Hartley: Well, it took. I always knew I wanted to do it, but for me, it took a long time, I guess, just in the sense that I knew I always wanted to do it, to get a PhD and so forth. But you know, I spent five years working at Goldman Sachs. I did a couple master's degrees as well. So it took some time to get there. But yeah, for me, I also wanted to spend some time sort of in the private sector seeing how things in the real world worked. And it's worked out great in the sense that it's informed some research well. But I take it it's a slightly different path for you.

Kenneth Rogoff: Yeah. So when I went to college, I had missed quite a bit, frankly. My high school was very weak academically. It's since gone into receivership. But I mean, I'm not sure what I would have learned at my high school either. But I lagged a lot at Yale and I was doing Russian studies. I was thinking about the environment. That was an idea. This was in, gosh, you know, the early 70s that I was an undergraduate at Yale. But I had a friend, Jeremy Bulow, he's actually, I think you know him, he's at Stanford.

Who, who he, like you knew, he wanted to do economics from high school. I think he saw Milton Friedman speak when he was 12 years old or something and just knew he wanted to be an economist and was making all the right moves. And he's a great economist, but he was evangelical and he brought myself, John Geanakoplos, who's the James Tobin professor at Yale today, he just roped us both into economics and said, this is something you should do.

And I think what I liked about economics was I, I felt like it was very flexible in what part of your brain you could use. At least in the courses, you know, you could have stuff that was very mathematical. Not that I consider myself great at stuff that's very mathematical, but, you know, I, I was solid and at the same time you could be doing history, which I liked a lot, and on and on.

I mean, one of the wonderful things about economics is you can kind of pick what you're interested in. So I like that. But during the summers I played chess. I stopped playing chess, but I had, I didn't play during the school year, not at all, but I played during the summers and actually kept getting better.

But that wasn't helping me as an economist because at some point it's very helpful over the summers to do something that relates to what your thesis might be, what you're thinking about. So I would say I was sort of a mile wide and an inch de deep as an economist.

I was a very good test taker. I don't think I understood anything that I was taking tests on, but if I just had to memorize something, I could do it. But playing chess in the summers was exciting and fun and I was doing well, but it wasn't maturing.

And then I went to graduate school and I didn't even know what being an economist was. I knew that if you went to law school, you had to work at a law firm in the summers. And I was thinking, I could go to graduate school and I could keep playing chess in the summers.

Boy, was I wrong about that. So when I got to MIT, Adam had happened to be in a great class with people like Ben Bernanke and Maury Obstfeld and Jeremy Bulow and many others. These people were, they lived, you know, their whole 24 hours doing economics and gave them a depth of understanding.

And it wasn't just about doing the homework. It was about really knowing what you're about. I didn't, you know, I, I sort of moved along. I actually dropped out of graduate school because I qualified to represent the United States in the World Championships, which was only every three years.

That, and I did, I played. I didn't do as well as I should have. I think I finished 11th, but I hadn't prepared a lot for that. I was trying to do graduate school. I was trying to chase. I sort of, okay, I can't do both. So I made a decision.

I would just do economics. But it still took me a long time to sort of mature to really be an economist. I had Rudi Dornbush as my advisor, as many people did. So inspiring. What a larger than life person. We compare him to Orson Welles or something. His love of pies, you know, his love of thinking, his love of debate.

And he drew. He was very exciting. I'd say Larry Summers was very influenced by him. Many of the people I named, he, he was, he was amazing. Stan Fisher was also his buddy. And I think they went running together and did everything together. They wrote a textbook together, and he was on my thesis committee too.

But I still wasn't an economist. And I think I was only in graduate school basically three years, and I just wanted to leave. And I remember Stan Fisher looking at my thesis and saying, Ken, do you really want me to sign this? And I said, yeah, I want to leave.

And he did. And I left and I got to the Federal Reserve, which back then was a bit of a backwater compared to what it is today now. The Federal Reserve research department's just amazing. I mean, you know, particularly in macroeconomics, but also in many other things. But back then, it's not something people wanted to do.

And actually Bob Solow and Paul Samuelson both said, what are you doing doing going to the Federal Reserve? I had some pretty good academic offers, not that I had a thing to offer, but they knew I was a really good chess player, and they were sort of willing to make me an offer because of that.

So I got to the Federal Reserve and I was at sea. They give you a lot of time to do your research when you're a new staff member. And I would like lie on the floor in my office. And I had no idea what to do.

It's very hard as a young researcher to figure out what to do. And it took a while, I think. I wrote one paper that was clearly a huge hit about why it was difficult to understand exchange rates. That surprised people a lot with Richard Macy that I would say stood up for many, many decades and even to today.

But the paper that really changed my life was people were worried about inflation in the 70s and what to do about it. Kydland and Prescott had written this very influential paper that Barro and Gordon extended, which was trying to explain it as a game theory problem, saying that you'd always be tempted to inflate.

And since the central bank moves second, they're always going to inflate and try to fool people. And the general conclusion was that the only solution, that's what Kydland-Prescott said, was to have a rule. But that really begs the question of if you have a powerful, not just Trump, but a Nixon, Reagan, Lyndon Johnson, you think that's going to stop them if the Federal Reserve has a rule?

No, they have a lot of say. And so because I was in the Fed and I didn't go to the university, I think I got an idea I don't think I ever would have got at a university which was creating an institution that was independent. That was a radical thought at the time.

It became. I think it's still my most famous paper. I couldn't get it published. I sent it to the JPE (Journal of Political Economy) for example, and Barro said, well, nice math, interesting. But the Fed would just be a veil. If the government wants to take it over, who cares? This is meaningless.

And I got different levels of reactions at different places it got rejected at the AER (American Economic Review), it got rejected at the QJE (Quarterly Journal of Economics). And to make a long this is already a long story shorter. Larry Summers heard of the paper and he loved it and he had become an editor at the QJE and he said I know we rejected this, but please resubmit it. But that paper I worked on really hard. I'd be up in the middle of the night working on it, you know, thinking about things and on chess I did that a lot, but I hadn't done that as an economist. And I mean I think since then I've been like that.

That was, you know, I think that's the moment it was about three years in that I be that I really became an economist.

Jon Hartley: That's amazing. And central bank independence especially newly relevant with the question about how whether or not Humphrey’s Executor will be overturned or not and the implications for the Federal Reserve continuing to legally be in an independent agency.

It's amazing your career path and clearly that work propelled you to Harvard where you are now, where you've been for some time. I want to start going through some of your I think key results and big pieces of work. A lot of these sort of encapsulated in various books.

And I want to start with talking about public debt, given that public debt is certainly topical right now. In your 2009 book you cover public debt a lot. This time is different. With Carmen Reinhart, you also wrote a related sequence of papers, the American Economic Review Papers and Proceedings, “Growth in a Time of Debt”.

And there's a related Journal Economic Perspectives (JEP) article as well with Vincent Reinhart. And you sort of argue that there's a cutoff for public debt to GDP that's maybe around 90 to 100% or so, after which once a country sort of goes beyond that level of debt as a fraction of gdp, economic growth gets really bad.

And you do this with lots of history. Many countries now, today, many governments around the world, including the US are passing that threshold of 100% of debt to GDP. How do you think about those results in light of ever increasing public debt today and what's your outlook for the US and global fiscal situation?

Kenneth Rogoff: So first of all, our 2009 book really didn't have anything about that. What it did have was the first historical data set on public debt. It was a archival discovery that you could do it there since been we we gave all our data sources and the IMF cloned it pretty quickly and some others have so that was something just new.

Nobody had longer term data that, that might make your head explode to think that's true. But it was. The IMF didn't keep it. They didn't. And even, even having OECD countries, those are the richer countries, they didn't keep it going back very far. Long story. So the 2010 paper, which, the first one was just a short weekend conference note, that was what the AEA papers and proceedings were back then.

We didn't say that when debt hits 90%, your growth suddenly slows. We didn't have any statistical test. We just divided debt into buckets over 20 countries and just said in the periods where your debt's really low, growth is on average higher than when your debt is really high and between 90% and below 90%. It's about a 1% difference. But the stupid interpretation of that, which some people did, and I would say particularly people like Paul Krugman who would use it as a character, made it sound like when you go from 89 to 90, your growth drops by 1%. And we actually very quickly wrote things. No, that doesn't mean when you go driving at 55 miles an hour and you go from 56 miles an hour, you're going to crash. But, but cars going really fast on average have more things. We use the example of cholesterol. When Your cholesterol is 199 and goes to 201, it doesn't mean anything.

But on average, if you take everybody with high cholesterol and everybody with low cholesterol, and so I think that result has held up very, very well. There's 15 years of research on it, but there was this whole people just felt, well that you must be in favor of austerity if you think debt is a problem.

And, of course, I should think it's a book by Ezra Klein, I don't know if you've seen it abundance or read it. He's progressive, but kind of comes to the realization that progressives don't understand trade offs. If you want to protect some little dart fish, but it means Los Angeles is going to burn down because you don't get water there. You might think about it and that actually this whole austerity narrative, stimulus good.

We say that very clearly, owing a lot of debt is bad. But they couldn't accept the trade off. And so the argument was there is no trade off. It's a free lunch. And that's been made by the modern monetary theory people that you probably mocked on your podcast at one time another.

But it's not that far from Summers secular stagnation. Certainly not that far from what Blanchard said in his presidential address and many others where they were sort of arguing interest rates are just going to drop and drop. So why are we worrying about this if you never have have to pay the piper, you don't care about debt.

But of course, if you look at a longer history of interest rates, and that's a major theme of my book and my I have an AER paper (American Economic Review) from August and 2024, Barbara Rossi and Paul Schmelzing. If you look at a long period, you have these periods where the rates are high, you have these periods where the rates are low.

But there's quite a bit of reversion to mean you always should have expected that. And if you don't mind my just going off on this a second lot longer: this whole notion ‘stimulus is wonderful. We have to have more and more. Anytime you're not doing stimulus as austerity and debt, you shouldn't care if it's high or low.’

And it's like I've said to some of them, okay, let's say you think that it's stimulus. They think it's fantastic that you know, the Keynesian multiplier is 2. I mean, depending on when you use it. And I understand, you know, use it, you need to use it at the right times. Unlike when Biden used a lot of stimulus during a boom. But on average it's high. It's very good to have ammunition. So I said, well, okay, suppose there's a debt fairy and they wave a magic wand and our debt in the United States, instead of being 121% of GDP, is 60% of GDP.

Just suppose, and the debt fairy says for the next 30 years, knock yourself out, you can do stimulus, an extra 2% a year for the next 30 years. And of course their progressive heads explode because it's so wonderful to be able to do the stimulus. And of course, you know, if they step back a second, what it is is they think it doesn't matter if the debt was 500% or 1000%. But I mean I think a lot of research shows that's wrong, that the debt interest rate does rise as your debt goes up. So I, I think this sort of perverse era where everybody thought it was a free lunch has now passed. At least you were at Goldman on Wall Street.

I don't know about in academics. It's still, there are a lot of people who think this is an aberration, it's going to go back down. But I mean I think that's, that's sort of the central question around US debt today. If you believe that this is an aberration that real interest rates are high and you're not persuaded by the argument that as debt grows the interest rate goes up as the world needs. It's an unfortunate position of needing to remilitarize the interest rate goes up.

Populism makes the interest rate go up. A lot of factors. If you're not persuaded by that and you think demographics is destiny, although Rossi, Schmelzing and I look at demographics over longer periods and it just doesn't work for explaining the real interest rate, then you shouldn't care.

But I think we've arrived at this moment where the interest rate has normalized after a long period of a radically declining post-Volcker The Reagan Volcker period had this huge interest rate rise. So I see the US fiscal situation as very precarious at the moment. Even if we had a normal deficit of 2% of GDP instead of 7 or 8% wherever we're headed.

Jon Hartley: I want to talk a little bit more about interest rates and monetary policy. So maybe a little bit more about short term interest rates for a moment. You wrote a book in 2016, The Curse of Cash. You advocated for abolishing paper currency in part. One of the reasons you gave is that it tended to be used in criminal activity or at least higher denominations of banknotes.

And you sort of argued that, you know, it also makes sense in terms of implementing negative interest rates. It makes that easier to do because if there's always this option that you can put money in cash, you can lock in a 0% interest rate. And so I think, I know Sweden sort of largely abandoned paper currency, but I think that's one of the few cases.

I'm just curious, does the recent also maybe the recent backlash against central bank digital currencies not sort of cut against the idea that paper currency maybe should be banned? One of the reasons why I think central bank digital currencies are generally very unpopular. If you look at some of these surveys, people don't want this idea that there's some digital currency.

That's the only option that can sort of be maybe taken away from them. If you had some sort of a malevolent government or dictatorial government. What about, you know, the, I guess, you know, to just sort of make the counter argument in favor of maybe, you know, keeping cash legal?

What about the people who say, you know, the ability to have cash on hand, whether it's under a mattress or whatever, sort of a fundamental freedom meant to sort of check the power of governments. I'm curious what you say to sort of those, some of those counterarguments to those that are sort of in favor of getting rid of cash.

Kenneth Rogoff: Well, so my book's a little more subtle than abolishing cash. It is phasing out large notes and then, and over a long, long period and seeing where you stand then. And you know, a huge percentage of all cash is held in large denomination notes. In the case of the United States, about 80%.

It's $100 bills. And of course that's compared to when I wrote the bill. The hundred dollar bills is like a $75 bill now thanks to all the inflation. So that's good. I argue that a huge percentage of this is used to evade taxes. And I think that's true.

And a lot of the people that are really angry about it want to evade taxes. They think they shouldn't have to pay. And okay, I don't want to have, you know, infinitely high taxes, but when some people aren't paying taxes, people with the same income who don't have a cash business do have to pay taxes.

I, I think that, you know, we, we absolutely, the privacy issue is absolutely an issue. But I think into the foreseeable future, if you had tens and twenties, like, what are you planning on doing that requires you to have $100,000 in cash? And I think we can debate that, but it's like, you know, there's, there's again a trade off in the privacy question.

I was criticizing progressives before. I think I'm criticizing conservatives now. Privacy is a right up to what point? Like Is it your right not to pay taxes? Is it your right to do major, you know, violations of the law and a few thousand dollars, who cares? And you know, I think, I think it is a question of whether we arrive at some kind of digital currency that people can use that provides some privacy.

And crypto is definitely expensive for the government to trace. And crypto competes heavily in the underground economy. Now I have papers on this and I talk about it a lot in my book. In fact, you know, the dollar, the underground economy is probably 20% of global GDP. Again I have another paper on that and again do surveys of it.

And the do that's a big part of the dollar. The, the paper currency dollars market is the underground economy. And the dollar is losing in that already, that there ways crypto is more efficient. So you know the privacy issue, it's a question of balance. Where do you want to strike things?

So on the negative interest rates is a different topic. You actually don't need to abolish cash. You don't even need to change anything to have net negative interest rates. And the Europeans and the Swedes didn't go this route. They didn't, they didn't do it the right way. And you can have very negative interest rates by having an exchange rate between cash and bank money and having the exchange rate depreciate over time.

So if you're holding cash, the value of it when you take to the bank, the bank, meaning the Federal Reserve, goes down over time whereas your bank money where you're getting a negative interest rate doesn't go down. So that idea has actually been around since the 1930s. I discuss it in the book.

But in general, if interest rates are getting to the zero bound and we were to get in another situation where we really wanted to use monetary policy to stimulate the economy. But I think negative interest rates have just not been tried. You have to have the legal changes.

But we have very negative real interest rates obviously. I mean that happens all the time. German bonds have had negative interest rates more from the market than ECB policy. So I think it's an open question. In fact we have a review coming up now of the Federal Reserve.

After every five years it does a monetary strategy review. I don't know if you're, are you following that by the way?

Jon Hartley: So absolutely, absolutely. It's talking about at length at the Hoover Monetary Policy Conference just last week.

Kenneth Rogoff: And so what do you think about what they did in 2020, the asymmetric policy?

Jon Hartley: Yeah, the flexible average inflation targeting (FAIT), in my mind it was built for the prior 10 years, in the era of being at the zero lower bound. And the biggest struggle in the minds of I think some central bankers was trying to get inflation above 2%.

And at the time that was seen as a huge issue. Now with sort of a few years of way higher than 2% inflation, I feel like maybe there's going to be some calibration away from that. And it was asymmetric, and there's Bernanke's sort of temporary price level targeting idea.

Yeah, I mean all, all very interesting questions, but yeah, I think, I guess there's a good question about, I mean it's very interesting that the Fed never went negative. And my understanding is that Bernanke did so not to disrupt money market in general; money market funds. But, the ECB did go very negative and I mean to a point in the sense that they were constrained by I guess this fact that there's still.

Kenneth Rogoff: They hadn't dealt with cash, they hadn't dealt with preventing from people from hoarding cash, which the ideas I have and the other ideas I talk about would. So they never. And because they hadn't dealt with it, it made the negative interest rates less effective because everybody knew they couldn't.

There still was a lower bound. It just wasn't the same. Well, I mean, I think, I think if we run in that situation again and at least a lot of people your age doing research don't agree with me and think interest rates are just going to go down and down and down and we haven't seen anything yet.

I mean, I think you have to think about negative interest rates and we have to rethink that. It would involve making some, I think fairly minor institutional changes to be able to accommodate it. So if they don't do that, if you don't do that, it causes all kinds of distortions.

But if you do that, it's seamless at least. I mean, I, in my, and so I was a discussant at the Fed 2020. I also spoke at your Hoover Monetary Conference and they let, they welcomed having me talk about negative rates. But the Fed was like, please don't, you know, like.

But what the policy they came up with was a disaster in the end. And I think they were influenced by it because they didn't feel they had a tool for what happens if interest rates fell to zero. So we can come back to that. But I, I regard that As a very live issue, not near term because I agree the inflation we've had the last few years has sort of disabused anybody of the idea that inflation's always zero. But it certainly could come back.

Jon Hartley: I agree. I mean, I do think that there's a lot of controversy and, and need for retrospection when it comes to flexible average inflation targeting or, or even forward guidance.

I mean, how useful is forward guidance now when you know, we're no longer at the zero lower bound? And so it's at least for now.

Kenneth Rogoff: But I thought everything they did at the Fed was kind of meaningless. So first of all, forward guidance. And Larry Summers has said that, I've said it too, but Larry Summers has said, I say in my book, but Larry Summers said it very eloquently, that the only people who are listening to the forward guidance is the Fed.

And it ties their hands. The market pays zero attention. And the flat and the thing of average price level targeting, well, okay, but when the Fed overshoots with high inflation, where's the low inflation that makes up for it? I mean they forgot about it the second it happened.

It's not credible. Political economy matters at the Fed and it's not credible. I thought while we're at it, I thought quantitative easing after the initial wave of the financial crisis ended was absolutely a bad idea. Like it's just smoke and mirrors because the Treasury owns the Fed.

The Fed is buying the Treasury's debt with the one hand, it's issuing short term debt with the other hand, which the Treasury owns. And it just gets really nonsense, and I think led just to some distortions in markets. But in some sense there was, you know, this feeling that they wanted to do something.

And the Fed's still paying the price for that today.

Jon Hartley: Yeah. I did some work a number of years ago that was an event study looking at the announcement effects at least of quantitative easing, announcements of regular, Treasury MBS purchases and so forth and in across countries when emerging market central banks started doing this during COVID too.

And I think there is some case being made that means 20, 30, 40 basis points of an effect on the 10-year yield which I guess is simulative.

Kenneth Rogoff: So you would get the same effect by having the treasury do what the Fed did. The treasury could just issue more short term debt and less long term debt, it's not really a monetary policy.

Jon Hartley: Absolutely, in fact I have a separate debt management paper called “Does Government Debt Management Matter? High Frequency Identification From U.S. Treasury Quarterly Refunding Announcements” And it kind of makes the case that maybe the Treasury should be issuing more short term debt.

If there's all this demand for short term safe assets, maybe the treasury should be doing that. Anyways, separate discussion, but I think the biggest challenge to me just, and I think it's maybe more of a political economy challenge which is like the quantitative easing. It's just something that the Fed can't seem to get rid of in the sense that anytime basically potential markets and banks adapt to this new environment and then when they try and run down the balance sheet, you hit something like the repo crisis of 2019, suddenly they revert back.

And so maybe if there was the right kind of communication and the right strategy, this could be done, I mean maybe a Fed chair, Kevin Warsh would do something like that. He's been very critical, very consistently very critical of this sort of non-emergency lender of last resort type of quantitative easing and just buying Treasuries and remaining mortgage backed securities as well.

And so maybe, but I think it would require certainly an incredible amount of resolve in the face of, you know, pretty significant, you know, market disruptions to see it through. And maybe that will happen, but we'll see.

Kenneth Rogoff: Just want to say that's an example of where your background at Goldman Sachs and I have students who work a couple years ago at Goldman Sachs. It's very helpful to understand that kind of issue because you, it's really institutional and understanding markets. It's not just about, it's hard to express it with just math, you really need to have a textured understanding of markets.

Jon Hartley: Absolutely, and this adaptation thing that goes on too, it's very complicated in the sense that how markets sort of like certain things and latch onto them.

And it's kind of how I guess some of these markets and the prices reflect that. I want to talk a little bit more about your new book that just came out this year in 2025 called Our Dollar, Your Problem.

Kenneth Rogoff: Came out on May 6.

Jon Hartley: So it just came out and a lot of it's on the status of the US Dollars of world reserve currency, which it's had since the Second World War. And some of it is also a retelling of your own personal experience in international economic policy, you're the IMF chief economist.

You spent a lot of time at places like Jackson Hole and many other places around the world. I'm curious, what are some highlights of the book in your mind? And what are your general thoughts on the dollar reserve currency status? Another topic that's very popular right now.

Kenneth Rogoff: Yeah, so I did weave in personal experiences with world leaders, policymakers.

It's not a memoir, it's just a little bit, I think chess is in there quite a bit. Just I wanted to give, first of all, put people in the moment, I was there, I was a Yale student in the early 70s, and we were being taught in our under first year course. We were being taught in more advanced courses, I took advanced macro. We were being taught that Russia was going to catch up (in GDP) and if they didn't, they'd be 80% the size of the US and they would occupy a big part of the world. I mean, the idea that we were going to be, you know, occupy all those countries would become free and Russia wouldn't become an equal power.

That was not what people were thinking, and I sort of go over that. I also mention that my skepticism about it, not from any deep understanding of economics, but I had lived in Yugoslavia. That's the former Yugoslavia, which has Croatia, Serbia, Bosnia, Herzegovia and Montenegro and a couple other countries.

I lived there and a long time and they were supposed to be more successful than the Soviet Union. And the chess players were actually worshiped there. That was fun for me because that's certainly not the case in the United States, and they were privileged. And then I go visit their apartment, which they just so thrilled, like they won the lottery to get this apartment.

And it's little bigger than a bathroom, but in a bathroom plus a kitchen maybe. Well, they don't have plumbing in a lot of these things and with cement walls, colorless, and they think they're at the Ritz-Carlton living in it. And just I don't think we should ever believe it, but we did.

Japan, my goodness. I was working my first job at the Fed and Rudi Dornbusch was so engaged about what was going to happen with Japan. They were, I mean, he, I'm not saying that he believed this, but he was concerned, if they would pass us, he would call me all the time to think of what the Fed was thinking.

And at the Fed, we're in the 80s, nobody talked about China, we thought Japan was taking us out, Japan had higher, by some measures, per capita GDP. Its stock market was worth more than the United States, incredibly, its real estate market was worth more than the United States, even though it's a tiny island.

And I go over these, I worked at the Central Bank of Japan for a while and go over these moments where we did not know what was going on. And I think there are ways we got lucky to rise as far and by that I mean to just be so dominant that we ultimately became. I think the economics of this, of course, has only one currency, network effects. There's nothing else to say. The politics sure as heck doesn't have that, that the Chinese, they're going to break away, and when they break away, Asia is going to break away. And that's been going on since 2015, they're forming their own networks and pipelines and clearing. And the Europeans don't like it either, so it's not that there's a Canadian dollar with all due respect to Mark Carney, or an Australian dollar, nobody cares about them.

But there'll be a few tripolar system, which back in 2005 was the consensus in academics that we were going to have a tripolar system. And what happened the last certainly the ten years after that was a shock. Well, Europe had the global debt crisis, China didn't move away from its peg. And so what I argue in the book, fast forwarding a lot, is we lose some space to crypto and the underground economy, but we're going to lose market share to the renminbi for 100% sure, because they can't live with us. I mean, even if Trump is enforcing it, where other sanctions and the Europeans will also expand.

So there the yeah, there are these network effects, but pushing back against this is these other effects. And if you look at what central banks do, which is what my favorite measure with Reinhart and Ilzetzki, it's been in retreat for 10 years, probably the centrality of the dollar.

Jon Hartley: Well, I'm curious though. So I have a paper published in Economics Letters.

Kenneth Rogoff: You kindly said it to me.

Jon Hartley: Yeah, it's titled “De-Dollarization, Not So Fast”. And it basically just gathers these same measures of the dollar that we're used to seeing before. And Barry Eichengreen and others have published with older data. And so if you look at, you know, these measures of the dollar, you know, fraction of dollars in central bank FX reserves, the denomination of bonds, FX transactions or trade invoicing; if you update it through Covid and through the Russian invasion of Ukraine, the dollar status hasn't declined whatsoever through those sort of pretty big international events. And, you know, there's also the freezing of the Russian FX reserves and all these things. So I guess, you know, like, sure, you know, the dollar share of FX reserves is down from the early 2000s. A lot of people like to show some of those charts just starting in 2000 to today. But it's actually been at lower points, say like in the, in the 90s.

Kenneth Rogoff: That's because it, it fell after Bretton Woods. I mean, the 70s was a big decline in the dollar share of everything, which my book discusses why, given our debt situation and challenges to Federal Reserve independence, I am sort of expecting a 70s light maybe period now, which will also, you know, accelerate this.

But, you know, it hit it. It sort of fell because we were screwing up. And then as we became more stable, it arose. But I think the rise from the 2000s was very surprising given where the trends were. That's why people point to that.

Jon Hartley: I guess I'm just curious just to make a counter argument in favor of just dollar dominance sticking around for much longer than maybe we think. I mean, if you look at like, say that the share of FX reserves in the Renminbi that's actually fallen since the coven, Russian invasion, Ukraine, but other currencies like, you know, Canadian dollar, Australian dollar, New Zealand dollar, those are, are strangely ascendant. I mean, I'm just curious, when you think about in the past, what's led to the end of a currency as a reserve, as reserve currency, as a world reserve currency, it's typically like a land war on home turf.

Like, you know, the UK and World War II and their experience there. I'm just curious, but you.

Kenneth Rogoff: You don't have, you don't have to have the end of it to be losing market share. Typically the norm is there are few currencies that are used. I mean, the Spanish peseta was on top, but even after the Florin took over, the Spanish peseta was everywhere, even into the, the British pound was, even after World War I was still co-equal to the dollar. There is a political economy element. If you just do a model, you want to have one currency, it's hard to come out with another thing but that such a model has no political economy.

And the thing that is unacceptable for a lot of the world is the information flow that goes through the United States because everything's in dollars. A huge percentage of information on transactions of all types we can see. And I think a lot of the world objects to that.

If you, if you didn't have that, maybe. But for, you know, for China, it's, it's just unacceptable. And they're going to, I don't know what you people say at Hoover, but people I talk to in Washington, I mean everybody thinks China's going to blockade Taiwan, that that's just coming.

And of course we're going to have a big trade war and of course we're going to do sanctions. And in my estimation they have 2 trillion in dollars indirectly and they're, they're, you know, they're going to want to be bailing out of that and they're looking to. And it's not, it's not just about what, how they hold reserves.

That's by the way, I sometimes compare these things you're doing to like the, I know it's politically incorrect, but the blind met nine blind men touching an elephant and they each touch different parts and see completely different things. They're very small pieces, which is why I like what central banks are doing with their exchange rate stabilization as a portmanteau measure.

Why do central banks need to feel they need to stabilize against the currency? Why is it their reference currency? They're aware of dollar liabilities, they're aware of, you know, how much dollars are used in their economies or other currencies. And by that measure it's pretty striking how it's gone down since 2015.

So we'll see. I mean, you know, I don't, it's certainly possible that we'll stick around, but I would say just easily we could drop down to where we were in 2005.

Jon Hartley: I guess I had just a few sort of lightning round questions here and want to talk more about exchange rates specifically. I mean, I guess one, on the topic of China, do you think it was a mistake by the IMF to add the China renminbi to the SDRs in 2015, knowing what we know now or.

Kenneth Rogoff: Well, I mean, you want to try to bring them in, you know, as Lyndon Johnson said, you want them inside the tent, pissing out instead of outside.

And that has been the effort of policy. It has not entirely worked. But that was, that was, that was what I did. And by the way, we wanted their money like the IMF wanted the Chinese to give more money. The Chinese have not given that much more money, but they're sort of courting them and they may need them more given the Trump administration.

Jon Hartley: It's interesting and on the World Bank side of things too, it's interesting how much they've managed to hold on as a recipient as well,

Kenneth Rogoff: Which is hard to understand, yeah.

Jon Hartley: Given that they're much richer than the typical World bank aid receiving country. Yes. There's lots of geopolitics there to say the least.

So I guess I just want to get back to, I guess some of the more academic questions about exchange rates and really international economics. And really, I guess my question is what kind of progress do you think we've made in international economics and especially, you know, with understanding exchange rates in the past, say 20 years or so to, you know, 20, 30 years. I mean, PPP works over generally long horizons, maybe not small over short horizons. You've done some work on this. Covered interest rate parity. It's something that's I think taken the, at least the asset pricing macro finance literature by storm in the past 15 years just because it stopped working after the global financial crisis and all this bank regulation that prevented banks from sort of continuing to do this arbitrage. But you know, we've got all these other exchange rate puzzles, a lot of which you've documented, say with Maurice Obstfeld. Things like the consumption correlation puzzle (why is consumption less correlated across countries and output)? Or there's the Backus-Smith puzzle (why is the correlation between consumption real exchange rate zero).

Have we made any progress in international economics in your mind or is it slowed in some way?

Kenneth Rogoff: What's very tempting of someone of my age to say, we thought of everything a long time ago and there's nothing, but I don't think that's true at all. I think we actually live in a golden age of international macroeconomics. So, first of all, there is quite a bit of progress in thinking about exchange rates, but I'll come back to that. But would you judge finance by how well finance economists can explain the level of stocks, you know, or what they do? No. I mean, there's a lot of other topics international.

So, for example, financial crises. No one in closed economy macro was working on financial crises. That was an international topic. And people thought, it happens in other countries. And when the financial crisis happened, the international economists had way more to say the closed economy macro economists didn't have the right forecast.

They didn't understand things. And I'm talking about the Fed. Most macro economists, if you went to the big conferences, just got it wrong again and again and again. I don't want to name names, but I think those of us in international were all over this and, you know, we understood that.

Another topic, sovereign debt. It is quite remarkable that we haven't had sovereign debt crises so much recently. It's kind of incredible. Of course, by saying this, I'll probably make one happen. I think, okay, there'll be mistakes. I actually think we are about to have financial crises again in the next decade, given the higher real interest rates and the greater volatility.

But I think progress in international economics has actually been a factor in why that hasn't happened and how you should denominate your debt, particularly how you should regulate your banking system if you want to not have debt crises, how you what where the role of reserves is. And then on a really deep question, I consider the deepest question in international economics is why do countries repay their debt?

So I've worked on this a lot. The late Jon Eden did a seminal paper with Mark Gersovitz about this. And there's actually been a lot of thinking about this and progress about how to think about it. And I would say my take on it, and there's a nice book by Manuel Amador and Mark Aguiar and many, many papers on this, but I get a takeaway.

And Mark Aguiar, I think Jeremy Bulow and I wrote about this in the early, early 90s, but Mark Aguiar sharpened it tremendously. The basic idea being that if you're a country and you want to borrow, don't let, don't allow them to write contracts in New York courts, make them write contracts in their own courts.

And if you're a lender and you want to lend to Argentina and you want to trust the Argentine court, more power to you. But then if Argentina wants to default, they can do it in a jiffy. I mean they just do whatever they want and that way countries either don't get money or which for most of them would have been good.

Borrow money to use unproductively or they develop the legal infrastructure and such. I promise to get back to exchange rates. So I mean I think there's much more to be said. But first of all, the issue that the exchange rate plays a different role than we thought maybe 20 years ago, certainly 30 years ago when I had my book with Obstfeld, that its main role is between traded and non traded goods and there's, we have that in our book but there's much less role across traded goods because so much is either denominated in euros, dollars or renimbi starting to.

And not in your own currencies. And then of course there's the Clark medal when a couple years ago to Oleg Itskhoki who has these beautiful papers with Dmitry Mukhin and I don't know that I agree with everything. I don't wanna oversell it, but they try to. They, they basically argue that there's a lot of noise in exchange rates.

There's a lot more noise because of all the post financial crisis regulations, which is exactly why covered interest parity doesn't hold anymore. The, the banks aren't allowed to arbitrage it away. And they argue that in fact having a floating exchange rate is not as useful as people thought.

Fascinating debates here. I don't, I have thoughts about that where I think fixed exchange rates like Saudi Arabia has or Hong Kong has, very, very dangerous. But no, I actually think, I actually think it's been a very exciting period. You're at Stanford, the project that Matteo Maggiore, Jesse Schreger and Brent Neiman oversee of the Big Data Initiative has huge progress on understanding how things are denominated, what people are holding the home bias puzzle.

There have been a lot of great theses and international, so no, it's been, it's been a golden era I think. And if you continue in international economics, and I hope you do, I, I think you'll find it's, you know, continue to find new things that are exciting to work on.

Jon Hartley: Absolutely, I wanna talk about, I guess one other. This is the last question, you know, perhaps a new puzzle and that is what I'd say is the relationship between tariffs and exchange rates. And many have written on this in the past long ago when tariffs I guess were a bit higher, Paul Krugman, I think Rudi Doornbush and others, obviously President Trump recently enacted some universal tariffs on many countries that aren't targeted on just a few goods, as many tariffs in the past have been, but in generally speaking across the board on all goods from, well, it's not.

Kenneth Rogoff: Services, just goods, which is an issue in itself.

Jon Hartley: But to the surprise of many, the US dollar fell in response to the universal tariff announcement on April 2nd, rather than increase, which is sort of what would be predicted by theory and other past empirical evidence from say maybe smaller tariffs.

And typically the idea is that exchange rates were kind of this shock absorber and that trend has basically continued. So when there have been big tariff pauses announced, say I think it was April 8th when the deliberation day tariffs were paused for 90 days or the China tariffs being paused on May 12th, the US dollar rose significantly. And so that's sort of contrary to what theory would predict between tariffs and exchange rates. How would you sort of explain this in your mind if there's sort of some initial thoughts that you have on this sort of imperial.

Kenneth Rogoff: Well, certainly looking at the 2018. Well, let me back up.

So for the recent case, we knew they were coming. So to sort of look at what happens when they're announced, you have to separate, you know, what was unanticipated. But I'm sure you must think this too. I mean, the big effect was they seemed really incompetent. I mean, I am not somebody who has, has this knee jerk reaction to anytime Donald Trump says something or proposes something, it's terrible. I think he doesn't necessarily articulate things in the best way or most like an economist would want. But I think he's right about quite a few economic things. Let me limit it to that. But on tariffs, I mean, a lot of what he said is just illiterate.

The whole idea that current accounts are terrible for the United States, that running a deficit is terrible, as opposed to looking at, as, you know, subsidizing us for all this time. His idea that we can industrial, we can get great manufacturing jobs back. You know, machines may get the jobs, but people sure as heck won't. Not many. Well, our manufacturing has actually increased in recent years, but it's not because of tariffs. It's because we've had good robotics and our factories have been able to do that. But farming in the 1970s, the farming was fading. If you go back, of course, you know, 100 years, everybody was in farming or 150 years.

And all the TV ads in the election were saved. The farmer. They had people, you know, in farming. Well, we're, we're a giant in agricultural, but there are no jobs. And that's, that's future of manufacturing. Okay. There are national security issues, but that's got, that's just got nothing to do with, you know, bringing jobs back so narrowly.

On your tariffs question, I think people, I, I mean, I think it was just. He was incredibly incompetent. I mean, with you, I mean, he just seemed stuck on this terrible idea. It's not the tariffs that are terrible. If he just, you said, just put in universal. He just put in 10% tariffs, we could work around that, especially if he cut other taxes.

And yeah, some. I would have preferred a VAT tax to tariffs, but yeah, okay. But the problem was all this, you know, art of the deal. UK has to have free speech. You can go on and on with these crazy demands. So that's what happened. And so when people see him retreat, they say, we have Trump one, who was a pragmatist, and not Trump two, who seemed like an ideologue about this. That's what they're looking at is this competence question.

Jon Hartley: You don't think instead it's maybe like, I guess, a policy uncertainty factor or, or just, I guess maybe some reallocation out of the U.S.? It's a very strange fact that I think that exchange rates are moving the way they are and the dollar would rise, I guess, in response to tariffs.

Kenneth Rogoff: I'm not your basic Trump derangement syndrome person. I teach at Harvard, but I'm one of the 3% of faculty who would identify at Harvard as conservative (I consider myself a centrist). But on this one, just the faster he can retreat on this policy, the better. It's, it's not. Uncertainty is a very generous way to put it, but it created a lot of uncertainty. You don't know what the tariffs are going to be. You're sending a ship, you know, from one place to the other. You don't know what the tariff is going to be when you get there.

So if they can settle it, even on 20% tariffs, it'll be a big step forward. And I think the markets just encourage when they see Trump the pragmatist, which means on this case claiming victory, saying he meant it all along, but basically doing course correction, which I think is one of his good qualities, is being pragmatic when things don't work, adjusting.

And I hope that's what we're seeing here.

Jon Hartley: Okay. I really want to thank you for coming on. This has been an amazing conversation.

Kenneth Rogoff: Thank you. Well, thank you for having me on. And again, congratulations on the great success of this podcast. Great to be on it.

Jon Hartley: This is the Capitalism and Freedom the 21st Century podcast, an official podcast of the Hoover Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.

Listen to or watch the full Capitalism and Freedom in the 21st Century Podcast episode with Phil, which hosted at the Hoover Institution Economic Policy Working Group.

Jon Hartley: This is the Capitalism and Freedom in the Twenty-First Century podcast. An official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Today my guest is Phill Swagel, who is the Director of the Congressional Budget Office. He previously was the Assistant Secretary of the Treasury for Economic Policy during the George W. Bush administration from 2006 to 2009. And he recently was a professor of International Economics at the University of Maryland School of Public Policy. He was also a nonresident scholar at the American Enterprise Institute, a senior fellow at the Milken Institute, and co-chair of the Bipartisan Policy Center's Financial Regulatory Reform Initiative.

Welcome, Phill.

Phillip Swagel: Yeah, thanks so much. Thanks for having me.

Jon Hartley: Well, it's a real honor to have you on and to talk about CBO and how it works and its role. It's a really important role. I want to first start with talking about where you grew up and how you first got interested in economics.

I mean, you did your undergrad at Princeton and PhD at Harvard studying economics. I mean, where did that interest begin for you?

Phillip Swagel: Okay, well, so I grew up in Southern California. My, my parents were from New York, both of them originally from the city. They met at, at Columbia, Columbia and Barnard.

But most of my life I grew up in California and I was kind of always interested in the news and current events. So I was the kid at summer camp in Ojai, California. I would fish the newspaper out of the trash bin by the counselors' dorms or bunks or whatever and read it—it was the LA Times back then.

So I kind of always had that. So it's kind of natural that I'd be interested in something with, you know, with not politics, but current events, the real world. And then in college, I went to Princeton, as you said. You know, I just like that connection, the connection between kind of something analytic and in the real world.

Jon Hartley: That's fascinating, and I think, you know, many economists sort of, I guess first get interested in reading the newspaper and following what's going on. I mean, how did that interest sort of get fostered further when you were an economics major at Princeton, studying economics at Harvard? Who were your advisors and sort of biggest mentors in that whole process?

Phillip Swagel: Yeah, for me, it was really important and I just lucked out, I had fantastic advisors and professors. I took microeconomics from Harvey Rosen, who, you know, then I worked with when I was at the White House and he was a member and then chair of the CEA.

I took macro with the late Steve Goldfeld. Really phenomenal. He had been in the CEA with President Carter. My senior thesis advisor was really a brilliant man who's now retired from Princeton, Avinash Dixit. And my PhD advisor was one of his students, Kala Krishna was my first advisor and then Alberto Alesina was my second.

And then Larry Katz was also on my committee, who also is just brilliant and amazing. I had actually, I was just thinking, as you asked, my first year of the Ph.D. program. So this would have been the fall of 1987. The macro class was taught by a mix of Larry Summers and Robert Barro and they kind of alternated and which is great.

And Professor Barro, Robert Barro's brand-new at Harvard, and he was just fantastic and brilliant and insightful, but also so was Larry Summers. And the day I remember I was going to mention was the day of the market crash in October of 1987. Larry was teaching that day, you know, again, first year PhD macro, whatever he was going to teach.

He said, well, today I'm just going to talk about bubbles instead. And just, you know, kind of off the top of his head did a whole class on financial markets and bubbles. And it's great. So yes, academically, yeah, I really, really lucked out. And I could talk more about after school some of the people I worked with also.

And of course some of your friends and co-authors as well, like Kevin Hassett.

Jon Hartley: Well, that, that's terrific. And sorry, who ended up being the chair of your committee?

Phillip Swagel: So it was Kala Krishna, who's a trade economist and just brilliant. Warm, funny, insightful, and she's now a professor at Penn State.

Jon Hartley: Fantastic, I mean, what an amazing group of people to have as mentors. And I can only imagine what it would be like to be in a class with Larry Summers as the October 1987, I always forget, the Black Monday or Black Tuesday crisis.

Phillip Swagel: Yeah, yeah, exactly, exactly.

I think it was, boy, I think it's Monday. But yeah, it's a good question, I'd have to go back and look.

Jon Hartley: I always get confused. But I know it's a 25% drawdown in one day and it was one of the largest, I think still one-day drawdown.

I know it came back later in the day, but one of the strangest market anomalies that the economists still haven't been able to fully explain yet. I guess I'm curious. You became a professor at University of Maryland. You served in the Treasury during the George W. Bush administration, and now you're director of CBO.

I take it, economic policy has been something that you really enjoyed. What was your experience like during the Bush administration? You were there during, you know, the global financial crisis later in the George W. Bush administration. What was it like sort of working on things like TARP and so forth during that time?

Which feels like it was a while ago and we've had maybe a couple crises since, but I think it was definitely a turning point for economic policy. And you were there during that time. What was it like and what were you working on?

Phillip Swagel: Yeah, it's interesting. I mean, just like you said, sometimes it feels like a million years ago and sometimes it feels like yesterday and something will come up that reminds me and takes me back or I'll meet someone who I haven't talked to since then.

I mean, you know, it's a terrible time for the economy and the financial system, so there's a sense of urgency and there's a sense of mission as well, of, you know, what we were doing was important and, you know, obviously in, well, I say, in retrospect, rescuing the financial system and, you know, bailing out, I think, is the, the word people use.

And that seems like a perfectly fine word. Bailing out banks is controversial and unpleasant, but it was necessary. And that was something that I think, you know, even in real time we understood, you know, necessary, momentous, unpleasant, all those things. But, but overall, it's just the sense of mission, of working together and, you know, that the economy, you know, had to continue and the financial system had to be rescued as part of that.

Jon Hartley: That's terrific. And I'm sure, also, I think there's very few researchers who are able to stretch out both sort of the research world and the economic policy world. I mean, how, you know, after going back to academia, after having served in the Treasury during the George W. Bush years, how did that inform your research tastes and things you're interested in writing about, doing research on?

Phillip Swagel: Yeah, I have to admit my attention span is shorter. You know, going back, going to academic conferences. I think this is pretty common for even the most accomplished people with much better CVs than mine. After policy world, it's hard to go back to academic conferences. I've kind of always been interested in things that were real world, and so that wasn't so hard, thinking about financial regulation, that was pretty easy.

I had students who were interested in real-world things especially at the policy school. So for me, Maryland's a very congenial place, and the policy school is the right place for me. So moving back and forth between academia and policy world, it feels very natural.

And even at Maryland, which of course, is inside the Beltway, in suburban Washington, I was able to be pretty involved in some policy things as well.

Jon Hartley: Well, it's terrific. And I know many great economists at the University of Maryland who've gotten involved in policy and are really distinguished.

I think Mike Faulkender right now, who's the Deputy Secretary of Treasury. I want to talk about, CBO and really drill down into your current day job. I want to first get into why CBO matters as well as its history. So, the Congressional Budget Office, or CBO was created in 1974 by the Budget Impoundment Control Act, something we've been talking about a lot recently for other reasons, and things like surrounding DOGE and so forth.

But, there's what is CBO in my mind. I see it as the official scorekeepers passing legislation and when there's some sort of a cost requirement that features, sort of features primarily in the Byrd Rule and the reconciliation process. Something that the Republicans and US Congress are going through a lot right now with passing their tax reform bill.

Can we maybe just take a minute to summarize how the budget process works? Sort starting from, sort of start to finish, starting from the budget resolution to the passage of the law and sort of where CBO fits into that when it comes up with the scores and where does it really matter?

Phillip Swagel: Okay, yeah, sure no, it's. No, thank you. I mean, CBO is an agency of Congress, and we're here to support Congress. So we get them the information they need when they need it. And that's both the kind of what they need and the time, the when, and that's really our key role.

And the budget is obviously the budget process is a key part of that. Let's think about the reconciliation that they're working on now, right? Last week, Congress passed the budget resolution. That's a concurrent resolution between the two chambers, the House and the Senate. So there's no cost estimate to it.

That budget resolution sets out the broad parameters in a sense of the changes in the deficit that the overall, and then how each committee between the two chambers is going to contribute to that. And there's differences between the House and the Senate and there are different bodies. And so we are, we help them on a technical basis, right?

Coming up with the numbers involved in the resolution. And then we're helping the individual, individual committees that are working on the specific pieces of the legislation that eventually they will vote on. And so that, for example, health care, I mean, Medicaid is being considered. Obviously this is public record.

And so we work with committees of jurisdiction that work on Medicaid. In the House, it's E and C, Energy and Commerce is Chairman Guthrie. We work with his staff and we go back and forth as they refine ideas. We don't say do this, this is the right policy.

We, it's their policy. And we help them analyze what the budget implications are and what the other implications are. Eventually, the committees will come forward with legislation, and they'll have markups where the legislation is considered in public in the committee. And then we will come forward with a cost estimate.

And it's usually after the committee, after the committee process, we'll have cost estimates for each committee, so for each piece of what could be quite a large piece of legislation. And then at the end, the Budget Committee, first in the House, or probably first in the House, maybe then in the Senate.

It's up to them really, what order. The budget committees will stitch together the legislation coming out of the individual committees, and then we'll do another cost estimate for the entire thing. And we'll do that jointly with the Joint Committee on Taxation. And for anyone watching on video, well, you can see I'm pointing to the ceiling and I'm speaking from the fourth floor of the Ford House Office Building.

The JCT, the Joint Committee on Taxation, is on the fifth floor. And so all the parts of the legislation that involve changes to taxes to the Internal Revenue Code, they will estimate, but we'll work together with them. They're in charge of the tax, we're in charge of the non tax.

We'll do a grand estimate of it all. And then we'll do a dynamic estimate of the effect of the legislation on the economy. And then the feedback back to revenues and the deficit.

Jon Hartley: But you generally have your own models for analyzing, say, the effects of taxes as well.

And these are different from the JCT ones, I guess, so there's this whole budget process and I think a lot of people, it's obscure to a lot of people. In this idea that you what the House Budget and Senate Budget committees do, they come up with basically the top line numbers.

And then it comes down. Once those budget resolutions are passed, you think about passing a budget every year, then it comes into sort of lower committees or sort of downstream committees. The Appropriations Committees or say House Ways and Means, Senate Finance Committee, and so forth. The Appropriations Committees and the House and Senate, and so forth.

They're the ones that are doing a lot of this work in terms of working within that top line number that's been outlined. And then it's usually, I think after they've written a bill or come up with a markup that you'll go out and score it. Typically, I guess in between that and passing the bill and you do lots of things.

There's a lot of things that go into these scores. When CBO says it'll cost, X trillion or billions of dollars for this particular piece of legislation. I want to sort of break down into, I guess a number of key issues that go into each of these estimates.

One of them, which has become very topical right now is this whole idea of current policy versus current loss. CBO has done a lot of, traditionally done a lot of scoring under current law. I mean, some congressional Republicans right now would sort of like to switch to current policy to score.

So that the TCJA renewal bill and it's kind of a philosophical divide, I guess in terms of current policy says that we should have a baseline that's wherever the policy is today and use that as the baseline. And so, things like expirations and the law and so forth wouldn't be thought of as a change per se or part of the baseline.

For example, I think extending the taxes from Jobs Act looks inexpensive if we're, what we're doing is just keeping sort of the current provisions. If the current policy is the baseline, and the current law baseline is different in that it says sort of that the cost of expiring provisions does matter.

So it's really in my mind a philosophical divide. But I'm curious, how do you think about it and what should CBO and Senate Parliamentarian be doing? Is really your job just to sort of be agnostic to these sorts of issues? And just sort of come up with scores according to whatever sort of Congress is asking you to do, or where does sort of CBO fall into that in terms of, you know, current policy versus current law?

And how would you explain that issue? What do you think about it?

Phillip Swagel: Okay, yeah. It's an important question and something that the Congress is thinking about now. And the way you put it as a philosophical issue, I think is exactly right, that different people will look at it in different ways or look at it in both ways.

To say, like with the Tax Provisions, these are expiring. But a member of Congress might say, well, I think they should continue. And I just want to continue what we have now. And I feel like looking at it that way is the right way to look at it.

And another member might say, no, if the current law is this and the law has those provisions expiring, and that's the right way to look at it, we will provide the information that Congress wants. And that means we will provide comprehensive information this year. It means we'll provide both that if a member wants current policy basis, I mean, they'll have to tell us what is current policy, which provisions they think are current policy and are meant to be extended.

And, of course, I'll have to tell my colleagues upstairs at JCT what's current policy, since so much of that is the tax code, and we'll do that. And I mean, both agencies, CBO and JCT are here to support the Congress. And from the CBO perspective, we will give them the information they, you know, they want in the way they want it.

It'll be our analysis. Of course, we won't necessarily give them the numbers they want. It’s whatever the numbers are, that's what we'll give them. On the other hand, we'll also provide the current law numbers as well. And that's, you know, first is by statute that the statutory baseline is on a current law basis with some exceptions for programs like Social Security and Medicare.

You know, it's our job to provide Congress with the information they want when they need it, is our analysis. But they're the ones who decide what information is useful to them. And different members with different philosophies, you know, again, as you put it, will vote differently based on different information.

And I just want to make sure that the information we provide is comprehensive. And that's really fulfilling the CBO mission.

Jon Hartley: Terrific, I wanna get into dynamic scoring because this is another one of these sort of, I think, hot topics. So dynamic scoring, CBO and JCT, they have sort of different types of models, and they have both, what's called a conventional static model, which is where a lot of these sorts of numbers often come from.

And then, they also have these general equilibrium models that do dynamic scoring that account for how GDP and the macroeconomy might be impacted by such policies. And they're accounting for things like spillovers and things like that and are a bit more complicated in that respect. And I think one area, I think of confusion, I think for a lot of people, is that a lot of advocates of dynamic scoring.

Often, I think I sort of forget that conventional estimates still include elasticity, taxable income, which includes sort of behavioral responses to taxation. I'm curious, like, what sorts of behavioral responses would the conventional static model include in CBO's case? I mean, does it include your revenue shortfalls from, say, tax avoidance minimization due to, and things like due to wanting to work less?

How does CBO sort of separate out these sort of conventional behavioral response responses, say, evasion avoidance, tax minimization from the labor response in dynamic scoring? And I mean, do you think there's a lot of value added and say, I guess we'll get to dynamic scoring in a second?

Phillip Swagel: Okay. Okay. No, no, absolutely. And so I start with where you started, that the conventional estimates have a lot of behavior in them. And you mentioned some of them, some of the dimensions of behavior. And we have that the JCT in their tax models, they have that.

One thing we analyze where this behavior is important is tariff policy. And there's that the president is limiting the use of the de minimis exception as a couple of large firms in China that ship, basically small shipments to the US and those essentially get around the tariffs. I don't know if it's evasion avoidance, right?

One's legal, one's illegal. I think it's what they were doing was legal and now it's going to be off, you know, out of bounds, and that's going to change the nature of commerce. And we have to figure out, well, what will it mean for the supply side, you know, for those firms, and then what will that mean for the customers?

And so there's a lot of behavior in there. It's probably not going to shift the overall size of the economy. A lot of dollars, probably not macro scale. But how would that adjust? And so we've got to think about that. There's other things like no tax on tips.

I mean, that would be JCT, but they would have to think about, well, how will the nature of compensation change if, you know, could more activity shift over into tipped? You know, the kinds of things that have tips. And so that kind of behavior is important. Let me just mentioned one more, which is, I mentioned before, Medicaid policy.

We're doing a lot of work on that. A lot of the impact in the sort of the dollars, especially on the state side, and the coverage potential coverage changes comes about through decisions made by states. So the federal government will change the number of dollars, the allocation of dollars between the federal government and states.

And then, states have to decide how to respond. And different states will respond differently. They have different views toward Medicaid and uninsured and things like that. And we have to take into account of that behavior. So it's not of individuals, but it's of states. And we talk to the states, we analyze their situations.

But ultimately there's going to be our assumptions, our analysis built into those projections.

Jon Hartley: Fascinating. So I guess, like, okay, so I know there are tax models too. So like the things like evasion, avoidance and minimization. Break that out in a CBO, in the CBO tax model, or.

Phillip Swagel: It's hard. So for a cost estimate, JCT would do it. And they would have to think about that. About, you know, I guess, like the tax on tips, they would have to think about, right. How will the nature of work reconfigure? And what does it mean? So what does the behavior mean?

And we face the same thing with a tariff change. You know, how does the nature of commerce reconfigure itself? After legislation is enacted, then CBO is in charge of the baseline. And so, for example, the 2017 TCJA, the December 2017 Tax Act, JCT was responsible for the estimates.

But then once it was enacted, we put it into the baseline. And so in April 2018, CBO published kind of a long analysis of how we fit the newly enacted tax bill into the baseline and what did it mean for revenue and GDP and so on.

Jon Hartley: I'm familiar with some of that work because I know there's. I have some kind of related work with my colleagues Josh Rauh and Kevin Hassett on facts on investment. And I know there's sort of an elasticity that you can sort of plug into, I think your CBO CapTax model, which is more about investment than say you're just thinking about the revenues in your baseline.

I guess sort of just and we'll get to that in a second. We'll talk a little bit more about models and transparency and things like that. I totally commend the CBO and being more transparent than the JCT and that sometimes, we don't even know what the JCT's elasticities of taxable income really are.

We think they're sort of less than one, but it's hard because at some level it's not quite an apples to apples comparison in terms of say, how a literature estimate compares in that it's not clear what sorts of things get counted. Hence through the question on evasion, avoidance, taxation.

That's more a JCT question. But I guess I'm just curious overall conventional scoring or conventional static models versus dynamic scoring. In thinking about how these policies, how they impact GDP, what do you think? Do you think there's value added there in dynamic scoring? I mean, I feel like a contentious issue for a very long time in terms of to what degree we should think about the estimates that come out of really general equilibrium models, which is where these sorts of dynamic scoring effects are being measured often.

I'm curious, what's your take on sort of dynamic scoring versus conventional static models in general?

Phillip Swagel: Yeah, we want to do more of it and we've put a lot of work in over the last couple of years. I'm trying to think of since the 2022 reconciliation legislation passed, right?

The reconciliation bills tend to be kind of all consuming. Then the Congress was divided in 23 and 24. So the pace of legislation slowed down some and we had some time to prepare. And again, working with JCT and being ready for reconciliation, there are different roles. There's some things where legislation intrinsically has to have a dynamic score.

A big bill that affects immigration, you're changing the size of the labor force if the bill is large enough and intrinsically you're changing the size of the economy so that by its nature is dynamic. Something in tax policy where you have a really nice paper with Kevin Hassett and Josh Rauh that looks at the impact of change in tax policy on the economy or on investment, as you mentioned.

And in the economy, a big change in tax policy or even a small change that's focused on pro growth elements, that would change the size of the economy and then a dynamic estimate makes sense. And then there are members and many members who want us to do dynamic analysis on the spending side, sometimes they call at the investment side is a change in some policy that changes the size of the labor force, or maybe it's direct federal investment, building roads and bridges or highways or something else, that changes the productivity in the economy. It changes the size of the capital stock.

And members want that. And I want to give members of Congress the information that they think is valuable. And look, I think it's valuable too. I mean, the more the better, I can explain some of the challenges, but that's my overall philosophy which is that having comprehensive, more information to the extent we can.

And I can go into some of the challenges.

Jon Hartley: I'm sure you have to have some sort of an estimate of what a fiscal, your fiscal multiplier would be, I mean, there's all sorts of varying estimates in terms of fiscal multipliers. I mean, there's certain micro-estimates that I think tend to be pretty high and then from maybe things like RCTs and things of that nature, quasi-experiments of that kind of nature.

And that's from sort of more micro day. And then you have sort of the big macro sort of estimated elasticity. I think often of say, Valerie Ramey's work and the work of others, you know, Jon Steinsson, Emi Nakamura and others, that you look at these like defense spending shocks.

And so there's, I think, a school of thought that says that those multiple multipliers are pretty low and maybe as low as, you know, 0.3 or something like that versus the micro multipliers might be, say, around one and a half or two or something like that. And then some people argue there's, I guess, tax fiscal multipliers that are very different from government spending ones.

I think Alberto Alesina found that the tax multipliers were often bigger than the government spending multipliers. I'm curious. I assume those would be something that you'd have to think about if a member comes to you and says, hey, incorporate the dynamic effects of building a bridge or some infrastructure project.

Phillip Swagel: No, that, that's right. That's exactly right. And we did one paper like that. It was requested by the Senator Rob Portman, who was leading group with Senator Kyrsten Sinema and others that resulted in legislation on infrastructure investment. And that's what they wanted to know, that what's the dynamic feedback from infrastructure investment changes productivity, changes the size of the economy over a long period will feed back into revenues and they had in mind really roads and bridges, which, you know, takes, well, it takes in the US years to build a road or a bridge, you know, sort of infamously sometimes.

And then we looked at the 30 year horizon of the, you know, productivity and revenue feedback. It did not pay for itself. But depending on how the road or bridge was financed, there could be a substantial offset that the added productivity would generate enough revenue to pay for it was like as much as half of the cost of the road and bridge.

Leaving aside the crowding out, so leaving aside the debt that might be incurred to finance the road and bridge in the, in the first place. So there's still a sizable, a sizable impact that's on the spending side. And then, you know, like your work with Kevin and Josh on the tax side and the way I think of it and the way I explain it to members that different provisions have different pro growth impacts and the, you know, the sort of expensing, you know, think about like expensing versus a change in the corporate rate.

And the corporate rate is permanent, so maybe that's not on the table now. But think of like expensing versus the change in the personal rates. Those will have different impacts on growth. They're both pro growth, but different quantitative impact impacts.

Jon Hartley: Yeah, no, absolutely. And it's a huge, I guess, debate right now in Congress in terms of what to be focused more on sort of pro growth firm type tax adjustments versus, I guess, things are more, I guess on the individual side of things, things that were promised in the presidential campaign like tax on tips and things like that.

And doing questions I think right now, but maybe raising the personal rate, right? It's a very interesting dynamic in terms of how these things are being considered. The SALT deductions are a very big topic as well, but I wanna sort of get into this came back to sort of just CBO.

I wanna talk about just CBO scoring accuracy. So, you know, often our CBO scores wrong. I mean, I guess no score is ever perfect. But I'm curious, you know, we could think about, you know, the Taxes and Jobs Act of 2017 in the first Trump administration tax cuts which reduced the corporate rate and brought in expensing provisions for equipment.

And it also changed a lot in terms of how businesses pass through businesses are being taxed. And there were also changes to the individual code. There were opportunity zones. They capped the SALT deduction, all sorts of things in terms of your score or the CBO score for that.

And mind you, as a different CBO director who was there at the time, what did CBO get right and wrong there in your mind?

Phillip Swagel: Okay. And just to say, well, I started as CBO director in June 2019, but I own every mistake CBO has ever made and certainly members of Congress remind me of that.

And that's just, that's the reality. And you know, fortunately we get a lot right, but of course we get things wrong. And just as a general matter, the more familiar provision is and the more incremental legislation is, the easier it is for us to model it. And when something's entirely new or big, well, that's harder.

And you know, the ACA of course, was big and new. So just things like that are harder. The Childcare Provisions and the Build Back Better legislation, those were big and new. You know, we never, in the end, that was never enacted, but that's the kind of thing that's harder.

The 2017 act is an interesting one. You know, of course, JCT did the original score, but we, what people really think about now, it seems like, is our estimates in the baseline is our projections, the technical word. So in April 2018, we published the first baseline update after enactment and that included the impacts of the, of the legislation.

So both we had stronger GDP growth, stronger business investment, stronger GDP growth, lower revenues, right? That stronger growth would improve revenues, but not so much to pay for itself and so on. And the beginning of 2018 bore that out, right? Investment was stronger until about the middle of 2018 when we saw some of the first wave of tariffs had a hit.

CBO is really actually very positive on the investment impacts of the provisions in TCJA. The, you know, the lower corporate rate, the international provisions, the lower personal rates, our internal estimates, like the elasticity you mentioned, the change, essentially the change in the price of investment, you know, from the tax side, what does that do to the quantity of investment?

So we're not quite as high as what you and Josh and Kevin found, but we're within the range of your uncertainty and we're a bit above some of the other academic literature. So it's a bit of an irony that we are actually, we're very positive on the economics of the Act.

The revenue estimate that we did again back in this was published in 2018, April 2018. We are basically spot on for 2018 and 2019. That actual revenues came in actually very slightly below what we projected. So in some senses we were over optimistic, but really a tiny amount.

Now, of course, 2020 is a difficult year with the pandemic. There's so much going on, legislation. So let's leave that out because I don't think anyone could have projected what happened in 2020. 2021, after 21, until 22, 23, revenues were quite a bit higher than CBO projected. And so that's a mistake and error.

But of course the next thing is to say, well, why what happened and why were revenues above the projection starting in 2021? And I would point to a couple of things, right? Inflation is one. In our estimation, it is the biggest piece. That inflation, there's high inflation starting in the spring of 2021.

We tax nominal income. And so that means that the nominal dollars of revenue were higher than before, you know, before the high inflation. And I don't think the enactment of TCJA is what caused the high inflation, right? So I wouldn't attribute the high inflation to tcga. And so it's not fair to say, you should have, you know, should have anticipated that.

The Fed, of course, did put in extraordinary monetary policy in response to the pandemic that increased asset values. And then we saw that capital gains realizations look to have been extraordinarily strong in 2022. That of course, TCJA would have also improved asset values. But the sudden spike in 2021 and revenue surge in 22 looks like more the result of the pandemic and the Fed's response than tax policy.

And then the last thing I'd say is that of course, starting in early 2021, there is a surge of immigration and that, you know, for the federal government, well, there's cost of immigration, of course, but those costs are much heavier on the state and local governments in the US and for the federal government, the revenue impact is larger.

So again, revenues were higher than CBO anticipated because of the immigration surge. And I just don't think CBO could have plausibly expected the immigration surge in 21 back in 2018. And I don't think TCJA is what caused the immigration surge either. So that, I mean, I'm going on long here, but you get the point that revenues were above what CBO projected, but only starting from the time of the high inflation, the Fed's QE, immigration and other things.

So once you take that into account, our accuracy looks, look, looks a whole lot better.

Jon Hartley: Got it. So it's the cap gains I guess. And cap gains tax rates are not indexed to inflation.

Phillip Swagel: That's right.

Jon Hartley: The bracket creep there. And you're saying even, you know, undocumented immigrants are some degree paying taxes as well.

Phillip Swagel: That's right. That's right. And they're increasing the size of the economy. Well, many of them do, do, do pay taxes. Many of them in the immigration surge were brought in under parole, which essentially within six months many of them had work authorization, and then they had a big incentive to pay on the books because they'd have a date with a, you know, a judge and, you know, down the road.So they had an incentive to pay on the books, to work on the books and pay taxes so that they can show that to the judge. Yeah. So it's the inflation, equity prices driven in part by QE and then the immigration surge. All of those meant revenues in 2021 and on were higher than could plausibly have been predicted back in 2018.

Jon Hartley: Got it. So I know many of the Taxes and Jobs Act provisions are set to expire. In fact, they were made temporary to begin with because of some of these things like the Byrd Rule and things like that. But now there's a desire to make them permanent. That's sort of the big feature of the current tax bill that's being pushed through Congress. How do you go about modeling the impact of TCJA or Taxes and Jobs Act expiration in your macro baseline? I know sometimes you ask me why there's no recession being shown under the 2026 year under current law given to these expirations.

I'm curious how you think about those expirations from a modeling standpoint.

Phillip Swagel: Yeah, no, no, thanks. And, you know, first of all, to say, you know, there's no normative judgment here that when CBO says this, you know, this is what we think will happen, or this is the revenue or this is the GDP that doesn't say therefore it's the right thing to do or the wrong thing to do.

And members of Congress have many reasons and it's political philosophy and lots of things that are just beyond CBO and you know that. So that's where I start. We do have the expiration of the provisions in the 2017 act affecting the economy. And so we have GDP growth slowing in our baseline forecast.

We have GDP growth slowing from 2.1 in 2025. So 2%, 2.1% real GDP growth down to 1.8 in 2026, which you know, is a meaningful slowdown. But as you said, it's not a recession and it's kind of at, it is at odds with, I know with some people have in mind, this is quite a large increase in revenue under current law.

It's a bit less than 1% of GDP under current law. And you would think, well, that's going to slow down the economy by more than we have in our baseline. And there's a couple things going on that we have to, we basically have to model. Well, first of all, so much of the 2017 Act is permanent, including the most pro growth parts, right?

The corporate rate, the international provisions provide incentives for activity to be domiciled in the US and not to invert and not to go overseas. So that's, that's part of it is that a lot of the pro growth part is not expiring. The part that is expiring the most pro growth part of that is relatively small in terms of dollars.

This is some of the business side provisions essentially expensing and is the depreciation provisions. The bigger dollars are on the personal side. Now, every household faces, virtually every household faces a change in their taxes with the expiration of those provisions. But it's still also true that most of the dollars are associated with households with relatively high incomes and relatively high wealth.

And those households tend to have low marginal propensities to consume. So even though it's a lot of dollars, the MPC that comes with those dollars is relatively low, so the effect on the economy is attenuated by that. And so the effect on consumption and GDP is attenuated. And then there's the third and last part.

I guess there's two parts, 3 and 4. Well, one is we assume the Fed would respond in part to slowing economy under current law. The third that's interesting is that we talk to businesses about their view of the Tax Act and there's a, a substantial number of businesses said to us, well, we kind of understood that even though the provisions, some of the provisions were permanent, well, of course there could be subsequent legislation.

And so there's a sense in which in modeling their investment decisions, businesses might not have included the full permanent effect of the provisions just because they know laws change and even a permanent law can change. And again, that would tend to attenuate the impact. It meant that the positive impact of the law was not full force.

And then the expirations in the same way, which actually last thought, which makes the econometrics hard. So what you and Josh and Kevin did and what other groups have done is hard because you're measuring the provisions of the act. But then businesses are acting according to their own interpretation of the provisions rather than the actual provisions.

So we face the same difficulty, but it's a combination of those things that the expiration has a negative effect on the economy in our estimation. But it's not, you know, not sort of full bore and not enough to bring the economy to, you know, certainly to a recession.

Jon Hartley: Well, that's fascinating how you think about scoring things like that, there're some of those provisions that are set to expire, I wanna just talk about, I guess taking a step back here. CBO has hundreds of models as far as I'm aware. Now some of them are being made public, including your tenure, I think like the CBO CapTax model, for example, which measures the impacts of a tax change on capital and fixed investment spending.

I'm curious. One, how do we get more of these public and what do you think about things like I guess the CBO Show Your Work Act. This legislation has been sponsored by Senator Mike Lee, I'm curious. CBO is more transparent than JCT. I don't think any JCT models are really public at all, So I commend CBO for doing this.

But I'm curious, you know, there's, I think been a lot of interest in, in scoring and what goes into scoring in recent years. I think you see some of this with, you know, the popularity of, I guess, you know that you got the Yale budget lab now and the Penn Wharton budget initiative and all these things.

So, so I think there is demand for, for, for scores. But I guess, you know, there's always, I, I think what, what's funny about this sort of business is like there's always people who are upset about scores because too big or too small depending on I guess what, maybe what they hope to see.

But I'm curious, I think at some level, you know, putting more transparency into what's going into these models maybe could help alleviate some of that and thinking about how you change what exactly what assumptions are driving certain costs and so forth. I'm curious what is sort of the CBO plan for making models public and what do you think about this?

At some level I could see sort of negatives as well in the sense of why did you put that in there? And so forth, you know, so, so I, I don't think it's necessarily all peaches and cream, but I'm curious, what do you think about transparency? And how important is that to you as CBO director?

Phillip Swagel: Okay, no, no, and let me start by saying I agree with your assertion that the more transparent we are, it will help us when there are disagreements, when someone's unhappy with an estimate or a number. And we can say, look, here's the assumption in there. And if you, whoever's unhappy, if you think we're wrong with that assumption, well, let's talk about that.

And then it's a substantive discussion, it's a focused discussion, and we do that. And that kind of transparency is helpful and sometimes we'll just have a different view. I mentioned earlier, Build Back Better, the Childcare Provisions, we actually thought that those provisions would have higher uptake than the, the Biden White House did.

And so our score on that little part of it was bigger than theirs, but that was because we actually thought the policy would be more effective, in a sense, than they did. So these, my predecessor did a lot on transparency, as Keith Hall, and I'm continuing that. My colleagues are continuing that.

The CapTax model you mentioned is a great one, it has a limited user base. I know you are busy, like, very highly knowledgeable people for whom it's really important. You, people at Tax Foundation, Brookings, AEI, and, a couple others and it's worth it, right? It's the transparency, it's puts a little bit of a tax on us, but it's worth it because the community who uses it will give us feedback and questions.

And sometimes if there's something they don't understand or you don't understand, and you ask us in our tax analysis, staff are amazing. You know, say, yeah, you're right, we could do that better. And that's, that's kind of feedback that's helpful. We get helpful, we get feedback like that from congressional staff.

I'm sorry, I'm pointing out my window toward the Capitol, so I'm like, at the southwest corner of the Capitol Complex, and so I'm pointing to the northeast of the dome. You know, the health staff, where we work very closely with both, you know, both chambers, both sides on health legislation.

Sometimes, we'll give them a preliminary estimate and let's say, we expected, whatever, this to be different or that. And we'll talk about, we'll realize, well, no, they you have something, or they'll say, you need to talk to this outside expert and we will. So that's the kind of transparency that's useful.

I mean, it's all useful, but then. That's useful in a very mechanical, very immediate way. We put up other, as you said, we put up other modeling information, like from our healthcare health insurance coverage model. We recently, recently put up some information about health insurance premiums and our projections of private sector premiums.

I want to do more. The challenge is that it takes time, especially when legislation is moving quickly, we often just don't have time. And we all have time to talk about it with someone, but not to actually go and put it on our web, on our website, or in a way that's usable.

And we just can't stop and put up the models. And sometimes that's the time, sometimes the legislation is confidential, so we can't do it in advance. Sometimes it's judgment and I mentioned earlier, we talked about Medicaid and the state behavior. The state responses to federal changes in Medicaid is critical to understanding the effect of the policy.

And that's our judgment. There's no model in the mathematical sense, but there's our discussions, there's our judgment, there's our analysis. And so it's not easily encapsulated in something we post on the web. But I can sit with people, our experts can sit with people and talk about it.

And that's what I want us to do more of. And so the, Senator Lee's legislation, it's completely understandable and the kinds of things that he wants in that legislation, I agree with that. We need to put up more that, make it so that other people can understand what we're doing.

It's hard for us to do it in a way that people can replicate, which is ultimately what, you know, what he would like. That's just hard. I'm not sure we're going to get there in a broad way, but I want to do as much as I can, you know, to satisfy the motivation behind that.

And so I'm. Yeah, that's it. It's. In a perfect world, we would be there. He wouldn't even need the legislation. We'd be there without it. But given the constraints, you know, we have, I want to do as much as we can. Actually, can I just say a word that anyone listening to the podcast, we have a Contact Us email on the CBO website, it’s communication@cbo.gov and those inbound emails matter.

Or if a listener or a viewer, you see a CBO report and something looks wrong, well, don't be shy. We do want that feedback. We get plenty of feedback from academics, from members of Congress, from staff, from anyone. If something looks wrong, I want to know about it.

And especially constructive criticism is always, is always helpful.

Jon Hartley: Well, that sound very kind of you to be receptive to feedback in that way. I know many people have some very strong thoughts and feelings about various estimates. Actually, I asked ahead of doing this interview, I asked a few of my Hoover Fiscal Policy Initiative colleagues, Danny Heil, Josh Rauh, Tom Church and Ben Jarris, what they would ask you.

And so one of these questions that comes from Danny and a few others here is really, I'm curious what you think about sensitivity analysis and maybe doing some sort of CBO sensitivity analysis with an estimate. I mean, you tend to stick to point estimates, and I can understand why you might be reluctant to offer lawmakers, say, multiple figures.

It can also, I think you maybe leave you more vulnerable to getting things wrong and we could talk about the Inflation Reduction Act, Affordable Care Act, Medicare, prescription drug costs, some of the newer things that you mentioned before. They're difficult to model because they haven't existed before but I'm curious how you might think about that.

Or, obviously sort of macro variables are different from things like the response, various response parameters, both these things are subject to some uncertainty. But do you have any thoughts on maybe something like a confidence rating, attaching a confidence rating to some of your scores? The intelligence community, for example, uses an intellect confidence scale that allows analysts to indicate how confident they feel about their findings.

Uncertainty is always a difficult thing to measure. But I'm curious, would you ever think about, you know, sensitivity analysis and using sort of multiple estimates rather than just a single point estimate?

Phillip Swagel: Yeah. Yeah, and it's something that we think about internally. We've done some formal modeling, and some of the members of our panel of economic advisors have been helping, helpful in letting us do that in a kind of analytically sound way.

So the uncertainty around some of our numerical projections, budget deficits, growth, things like that, we compare ourselves to others, to the administration, to private forecasters. Of course, we could all be wrong. Many people were wrong about inflation in 2021, and we were one of them. So being with the herd isn't always the right thing.

But we do try to make those comparisons, we try to give people a sense of what the uncertainty is as best we understand it. And even in a cost estimate, we have a section on sources of uncertainty. We have a section on the basis of the estimate, what information went in, and then what do we think are the sources of uncertainty for the congressional process?

They need a point estimate and ultimately we don't have a choice, right? There's, we have, we do a cost estimate for everything that gets voted out of committee that's going to the floor. We don't get to pick and choose what legislation we're doing cost estimates on. And yeah, so there's limitations.

But yeah, it would be nice if, if we could do more to indicate this uncertainty where you said the intelligence community is kind of an interesting one, like the, yeah, just to say, hey, this one, we did it really quickly. There's, if we had infinite time or even another three weeks, here's the things we do and be able to come back to it.

That's kind of, that's kind of interesting. We come back sometimes to estimates, but like the Affordable Care Act and the mandates, the mandate in the Affordable Care Act, we published something explaining why CBO thought what the agency thought and how it was different than what turned out. But yeah, we could definitely do more on that.

Jon Hartley: Well, it's fascinating because I think about standard error bars and how useful they would be. I remember several years ago, Loretta Mester, when she was president of the Philly Fed, she recommended that FOMC policymakers should be allowed to include a standard error bar around their dots in the SEP.

And the survey of economic projections that they put out, they put out these, both forecasts of say, things like GDP, inflation, unemployment, macro variables. But also they put out their forecast of where they think the policy rate, where the short term interest rate is going to be in the next several years in the long run.

So imagine if they could include a standard error bar as well to sort of put in some level of uncertainty, maybe the market would react to it in a different way or be an easier way to communicate both, I guess a point estimate and some degree of uncertainty as well.

I'm sure we could spend all day talking about all these. Phill, I really want to thank you for coming on. It's been an amazing conversation. I know you're in a very key spot right now given the tax bill that's going through Congress. And I know CBO is spending a lot of time coming up with cost estimates during the reconciliation process and working with members very closely.

So really want to thank you for coming on during this very busy time.

Phillip Swagel: Yeah, thank you. Thanks so much. Thanks for having me on. And thanks to Hoover for hosting the podcast. And, yeah, I look forward to continuing the conversation in the future.

Jon Hartley: This is the Capitalism and Freedom in the Twenty-First Century podcast, an official podcast of the Hoover Economic Policy Working Group where we talk about economics, markets, and public policy.

I'm Jon Hartley, your host. Thanks so much for joining us.