 Good afternoon. My name is Kumball Sabuswamy. I'm Chancellor of the University of Massachusetts Amherst, and on behalf of the Department of Economics and the entire university community, it is my pleasure and honor to welcome you to the annual Philip Gamble Memorial Lecture. This lecture series is made possible by an endowment that was led by Israel Rogosa to honor one of our great faculty members. There is no greater legacy than for any faculty member to be left behind than to be remembered by former students and create a legacy such as this one. It brings annually to campus a prominent economist to speak on topics as critical and as current and diverse and interconnected as climate change, full employment, globalization, and the Wall Street meltdown. Visits such as this and such lectures enrich the lives of students, faculty, and the public alike, and we thank you all for being here. My task today here is to introduce Professor Michael Ash, the head of the Department of Economics and Public Policy and Professor of Economics and Public Policy and Chair of the Department of Economics in the College of Social and Behavioral Science. He will in turn introduce our speaker today who also happens to be his PhD thesis advisor. Professor Ash works at the intersection of many disciplines specializing in economic policies of health, environment, labor, and a particular emphasis on environmental justice. He teaches on the economics of health, on economics and public policy, macroeconomics, econometrics, and political economy. And he's certainly again in the tradition of Philip Gamble, a great teacher. Just last year his department recognized him with its outstanding teaching award. He's not only a respected colleague, but he's somebody with a deep belief in his disciplines important to the public good and public service. Professor Ash has served on the staff of President Clinton's Council on Economic Advisors. And just this year he presented before the Massachusetts Legislature's Joint Committee on Higher Education on the impact of economic impact of investment in public higher education. As the saying goes, no man is a hero to his valet. However, we're about to find out from Michael Ash what he thinks of his thesis advisor. Ladies and gentlemen, Michael Ash. Thank you, Chancellor, for that very kind introduction and welcome to all, to colleagues, to students, to guests. Chancellor, to Mahler. It's my pleasure and honor to welcome George Ackerloth as the 2012 Gamble lecturer at the University of Massachusetts Amherst. A little bit about George. He earned his BA from Yale University in 1962 and his PhD from MIT four years later. He devoted most of his career to the University of California, Berkeley, eventually as the Kaushalyn Professor of Economics, with time away to conduct research and offer policy advice in India at the President's Council of Economic Advisors, the Federal Reserve, the Brookings Institution, and now the IMF in Washington, D.C. George's list of accomplishments, awards, and articles is extraordinary. Most notable, of course, is his 2001 Nobel Prize in Economics awarded for his analysis of markets with asymmetric information. But that really tells only part of the story of his most famous paper, The Market for Lemons, Quality, Uncertainty, and the Market Mechanism. The mathematics in the paper is accessible to undergraduates or even intrepid high school students. The central metaphor and the title come from thinking carefully about the market for used cars, some of which, and only the current owners know which, are lemons. The insight can be demonstrated in the classroom using a deck of cards, and I have a three-card Monty version that I've used in health economics. So it's simple, but it's profound. And the central point of the paper resonates across disciplines, from health and education to finance, in every state capital, many national capitals, even in the core of Obamacare. And it almost didn't reach us, and that's part of a longer story. So after rejections at the American Economic Review and the Review of Economic Studies for, quote-unquote, triviality, George submitted the lemons manuscript to the Journal of Political Economy. In a Nobel essay, George described the referee's rejection letter. The referee's argued, and this writes George was the killer, if the paper was correct, economics would be different. Parish the thought. The story has some happy endings, and some endings are still in play. First, the Quarterly Journal of Economics recognized the importance of the paper and published it. George got tenure and has gone on to many, many more great things, including the Nobel and the Gamble. But, second, George has dedicated much of his career to making economics different. In a host of papers, some co-authored with his wife Janet Yellen, in an economic theorist's book of tales, in looting the economic underworld of bankruptcy for profit, in animal spirits with fellow Gamble lecturer Robert Schiller, and most recently in identity economics with his co-author Rachel Cranton, George has made economics different, and he's inspired others to make economics different. It's not a finished job, and it's one that we take to heart at UMass. George has brought the real stuff of society, fairness, confidence, corruption, the stories we tell, perception, and identity, to and back to a discipline that had taken dramatic steps to excise all traces of humanity. Cylonomics, perhaps? George is an extraordinary teacher, and I speak from experience because I was first a student and then a teaching assistant for his graduate macroeconomics course at UC Berkeley. I maintained copies of his lecture notes, which he wrote out newly and carefully by hand each time he taught. He would distribute photocopies of the lecture notes to students before the lecture, and we would delight in watching him follow his own stage directions, such as a race left-hand side of board, or pause. Let students realize that this is a joke, then continue. But the substance of those lectures was something else. A conversation about economics would unexpectedly turn into a conversation about car buying, home sales, childcare, or candy bars. I will never forget the Dr. Spock, or Keynesian approach to childcare and unemployment, versus the ferberized or monetarist approach. Similarly, the Modigliani-Miller theorem on the neutrality of debt and equity in corporate finance will forever evoke bundled packages of milk bars and nut bars, particularly on this day after Halloween. This afternoon, Professor Ackoloff will deliver the 2012 Gamble Lecture of the Department of Economics. The Philip Gamble Memorial Lectureship Endowment was established by Israel Rogosa, Class of 1942, and other families and friends in honor of Philip Gamble, a member of the economics faculty for more than 30 years in chair of the department for more than 20 of those. The fund supports an annual lecture series for ensuring a prominent economist. Previous speakers have included six Nobel Prize winners, including the late Eleanor Ostrom, as well as John Kenneth Galbraith, Barbara Bergman, Lonnie Guinear, Robert Reich, and Marianne Ferber. The Gamble Lectureship is also supported by the Charles L. and Martha S. Gleason Fund, Charles and Martha were economics graduates in 1940 and 1942, and both are now deceased. Before I turn over the floor to Professor Ackoloff, let me remind you that you are all welcome to a reception in the Cape Cod Lounge. Just beyond these doors and around the corner to the left. Following the 2012 Gamble Lecture, it is my pleasure to present Professor George Ackoloff. So thank you very much, Michael. I'm tremendously honored to be here, and especially at this tremendously fine economics department. I've been having a tremendously good time spending the day with all of you. And this is truly one of the great economics departments anywhere in the world, and one that is especially devoted to finding out and to pursuing the truth, and pursuing the truth that matters for absolutely all of us. So I'm very honored to be here, and I'm very honored, especially by Michael's very nice introduction. Okay, so let me begin. The lecture is going to be in two parts. The first part is going to be economics stuff, and I'll begin with a small model. There'll be only a few minutes of that, and this is just the beginning of a paper that I'm writing with Huitong at the IMF. Now, what it will do is it'll motivate what comes later. Can you hear? Can you hear? Okay, yes, thanks. Okay, so I'll talk a little bit closer and a little bit louder. So it's going to motivate what comes later. Then the rest of the lecture will be on a book that I'm writing with Bob Schiller called Fishing for Fools, which you saw up there earlier. That's meant to be a popular book. Now there are two motivations for that book. The first is that we're influenced more than we think by popular books. And the public and economists have too great an acceptance, I think, also of the view that whatever markets do is right. Of course, all of us would take into account the standard externalities as they're called, but that does not exhaust the reasons why markets yield bad outcomes. So we're going to explore the notion that markets also fish for fools. Now all economists, it turns out all economists know this, but that leads to the second very general motivation. The rule of what can and cannot be published in economics leaves holes. There's some perfectly valid and important things to say, but there's no way to say them that would be acceptable in any journal. Let me give you one example. For example, quite a few economists thought that financial derivatives would lead to the current crisis. But economists could not figure out, we could not figure out a way to express those views in the form of a paper. So I believe that fishing for fools is one of those holes in economics. Because we all know it, it cannot be published, but then because it cannot be published in journal form, it then gets ignored. And because it was ignored, we had the financial crisis, which is the central event in the economic history of our times and perhaps in the history of our times. So with those prefatory notes, let me begin. So I'm going to give you an elementary model. So as Michael suggested, I wrote a paper some time ago called The Market for Lemons. And so today we're going to have a, I'm going to do an extension of that, which gets actually very different conclusions from what we got in the original paper. So with a small change in that model, what we're going to see is we're going to find fishing for fools. And what that means is that everything that I say subsequently is not going to be just gibberish. That means that there's a precise interpretation, a precise interpretation of what it means. So let's begin with the original paper. In that paper there was asymmetric information. What does that mean? It means that the sellers of used cars knew the quality of their car, but the potential buyers of that car could not tell, they did not know what that quality would be. So we're going to begin, I'm going to initially run through it with the assumption, the common assumption in economics that the buyers are smart. In this case, what that means is it means that the buyers understand, they understand that if the sellers have a particularly good car, they're going to keep it for themselves. And if they have a bad car, that's what they're going to dump into the market, that's going to be a lemon. And then there are going to be two questions that we can ask of this. What are the consequences of the asymmetric information for the volume of trade? And what are the consequences for the welfare of the buyers? So I'm going to go through the original model, and I'm going to tell you about that. And we're going to take some time doing that, you have to be patient on it. So here's the original model. So first let me describe the sellers, what the sellers do. So they're used cars, one, two, those used cars differ in quality. Three, that quality is uniformly distributed, it's uniformly distributed between zero and two. We'll come back to that. Four, all of these used cars are initially owned by the sellers. And then the sellers get $1 worth of utility from one quality unit of used cars. And then six, the sellers know the quality of their used cars, but the buyers do not. So that describes the sellers, now let's go to the buyers. There are also potential buyers of used cars. Those potential buyers then, remember the sellers got one unit of utility from a quality unit. The buyers get three halves dollars worth of utility from one quality unit. And those buyers then in this version have rational expectations about the quality distribution of quality of used cars that will be sold. So they know what the quality, the distribution is going to be, is going to be sold. So just to be formal about this, we can represent this formally. And I'm going to skip that. And I'm going to tell you what I skipped. So it was just skipped points at the following, which I've already pointed out. Sellers value a quality unit of used cars at one. But the buyers value a quality of used car at three halves. Sometimes you've got to remember that. So typically in that case, you know what would happen in traditional markets. If the buyers and sellers have the same information, usually all of the used cars will be sold by the sellers to the potential buyers. Why? Because I said the buyers value the quality units at three halves and the sellers value them at one. So such trade is what a free market will produce if the buyers have sufficient income. And we have, and both buyers and sellers know the quality of cars. Okay. So now I've reviewed the assumptions. But what does our model produce when the sellers know the quality of their cars, but the buyers cannot tell the quality? So what's the equilibrium? Okay. And the answer is simple. The answer is simple, that there's no equilibrium trade at any price. And the question is, why not? And so I'm going to go through the proof as to why not. Okay. So here's the proof. We'll make a proof by contradiction. We'll show that there will not be any trade at any positive price P. Okay. So let's suppose, let's just suppose that there is a price for cars of P. First, let's examine what the sellers will do and we'll see what cars they will offer. The sellers value a quality unit at one. Remember that. Therefore, at a price of P, the sellers will offer all those cars that have quality less than or equal to P. So the sellers are going to offer the quality cars with quality between P between zero and P. What does that mean? Since the car quality has uniform distribution between zero and P, it means that the average quality that these sellers are going to offer is going to be P over two. So P over two will be the average quality of used cars that are offered. So that tells us what sellers will do if cars are selling your price P. Now we have to look at the buyers and we're going to look at the buyers and see what the buyers are going to do. And what's our question? The question is, are the buyers willing to buy? So let's examine the buyers. Will any buyer be willing to buy at this price P? And now we're going to do a calculation. Okay. The answer is no. Why not? The expected use value to a buyer will be three times times the expected average quality. So it's be three tabs times P over two. Okay. So then we have to remember that the buyers are smart. They know that sellers are going to adversely select the cars. And so they first see that if the price of the car is P, the average quality of the car is going to be P over two. And so they see that the expected, what they get out of a car is this three halves times P over two. And that's three quarters P. Now then the smart buyer will note that she's going to pay the price P for the car. So she does the calculation that her expected net gain in utility from purchasing the car will be this three quarters P, the three halves times P over two minus the price she pays. So any buyer who is going into this market will expect to get minus one quarter P from buying this car, whatever that price piece would be. So what's the conclusion? So there is no gain to the buyer at any positive price. And so any smart buyer, and these are all smart buyers, are going to stay out of the market and there's going to be no trade at all. So what's the conclusion? The conclusion here is that trade disappears with asymmetric information. So that's the original paper. I've gone over everything that Michael told you about except that it was rejected. Okay. So now let's change gears a little bit. So I've used this example, which you may know, but it also sets the background for an alternative model. So we're going to deal with this alternative model. This model has only a slight, a very slight change in assumption, but it yields quite different results. Let's assume as before that there's asymmetric information, but the buyers are not smart. Let's suppose that those buyers are naive. That means here that the buyers do not perceive that the sellers are going to selectively choose the worst cars for sale. Instead, we'll say that the buyers think the sellers will offer the cars randomly by quality. Remember, these cars are distributed between zero or two and they're uniformly distributed, so they think the average quality is going to be one. Okay. So if the buyers value a unit of car quality of three halves, that means that they're willing to pay three halves for cars. And it turns out that three halves is going to be the equilibrium price. So that's going to be the price. Now let's go back to the sellers and we're going to see whether those buyers are going to get a bargain or not. And actually, we already know the answer because I've already derived it for you. The sellers know, as we said before, the quality of car they own. So at the price of three halves, they're going to keep all cars of quality greater than three halves. And they're just going to push on the buyers all the cars between zero and three halves, the cars that are less good, the lemons. And so what's the net result? The net result is the average quality of cars that the buyers are going to get is going to be the average of those cars between zero and three halves. So the buyers are going to get a car of value three quarters. So the average quality of cars that the sellers are going to offer is not going to be one that the buyers were naively expecting. Instead, it's going to be three quarters. And what it turns out is the buyers will then get a bad deal. Using the exact same logic that we used earlier, the buyers will use one quarter of the price they pay for the cars they buy. That's what they're going to do. But this time, last time, what happened is there was no trade at all. This time, something worse than that happens is not only that there's no trade at all, there is trade. But these poor buyers, they're getting the lemons. So they're going in because they're naive. The sellers are dumping on them the lemons and they're going to lose one quarter of the price they pay for them. And so this is a sad story. So here we are. We have a market that actually is worse than the original lemons market. The lemons market was supposed to be really bad. We didn't get any trade at all, but there should have been trade. Here we have something that's really a lot worse. The buyers are stupid and those sellers are going to dump all their bad cars on them. So that's the story. Now you're supposed to draw a conclusion from that. So what's the conclusion for that? So in this model where there's naivete, markets do not benefit the buyers. Markets instead play a dual role. So they're doing two things. Some buyers are going to gain, but on average they're going to lose three-eighths per car that they buy. So what does this show? It shows in a very simple example, this is a very, very simple example, something that we all know. Everybody here in this room knows this and actually even every economist knows it. It shows that markets serve two purposes. They serve a positive purpose of letting people trade according to their relative preferences. And that's what usually happens in economics, but it also shows something else. It shows that if people are naive, if people are naive, markets are going to take advantage of them. Because of their naivete, they're going to suffer a loss in welfare. So this small mathematical example then serves as an introduction to this lecture. It's the basic theory behind fishing for fools. So I've given you this model as motivation and it's going to underline everything that's going to follow. So this is both an early trial run of the work with we and also the book that I'm trying to write with Bob. So there's going to be no more mathematics or models and now we switch into popular mode. And hopefully we'll see that maybe this small model we've looked at has some applications. So we're going to see whether there's some lessons. Okay, so it's almost a law of nature. From nuclear generators to chainsaws, our most powerful tools are also the most dangerous. Every knife is a two-edged sword. So the world's most powerful social and economic tool is the free global market. So what it does, it enables the world's adults to trade with one another. So worldwide there's some 25 Chinquillian possible pairs of buyers and sellers. And as you can see, a Chinquillian is a large number. So the selection that this huge amount of choice offers to both buyers and sellers, it makes us all better off. But that's just the beginning of the power of markets. So I just gave you Milton Friedman, so this would be a Milton Friedman line. Okay, markets are also beneficial for another reason. Okay, why? Because anyone with an idea regarding how they can offer a better deal quite possibly can make a profit on it. Such ideas are then going to be selectively sought out and adopted. Over the course of the last century, if each one of us had only one such idea once a month, four trillion new ideas would have been generated. That's a lot of ideas actually. The selective adoption of the best of these new ideas as allowed by the free market has powerful effect. So just to think about that power of effect, over our lifetimes we will see a lot of change. So mainly because of these new ideas, our standard of living will go up by something like six-fold over the course of our lifetimes. Thus, for example, in the U.S., our older retirees, those over the age of 80, they were born in a country that was poorer than present-day Mexico. Okay, so I've just stated Paul Romer's economics. Okay, so markets are capable of such power for good because they allow so much positive selection. But they can also allow a great deal of harm because they also allow negative selection. Not all of those four trillion ideas are good for you and good for me. Some of them are good for you and some of them are bad for me. And associated with such ideas come the tricks to invagle me into buying in. So thus, free markets do not just produce good for you, good for me, they also may produce good for you, bad for me, and vice versa. So furthermore, they also systematically aim for a weak spot. So what did they do? They seek out and take aim for our emotional or cognitive weaknesses. They seek to block our channels of information and then take advantage of those weaknesses. They seek out and take advantages of our failures to understand, which often occur, our failures to understand that we don't know what we don't know. So what does this mean? What this means is that markets enable, they enable fishing for fools. So fishing for fools. So what is a fool? So what is a fool with a pH? So fool with a pH is a new word and such a word should already exist in English, but it does not. In standard English, according to its dictionary definition, a fool with an F is a stupid or silly person. This reflects, I think, a deep philosophical mistake. It's perfectly possible to make an error, but still be quite rational and quite intelligent. You can make a perfectly intelligent decision, one that would be natural and easily made by an intelligent person, but it turns out to be a mistake. Someone who makes such a mistake by our definition is not a fool with an F, he is instead a fool with a pH. So that's a fool. Let's now think about fishing. So fishing is a computerese. Let me just see that on the right spot. I think I give you one. Yeah, I think. Okay, there's four. Okay, so now let's talk about fishing. Fish is a recent word, fairly recent word. It's computerese, but we should use it with a much broader meaning. Free markets open us up to be fools with a pH. They open us up to those who seek to influence us to do what they want, but that's not necessarily good for ourselves. They allow us in other words to be fish. So we live in a world where some six billion adults can fish us for being a fool. We have intentionally opened ourselves up to such exploitation because of the obvious advantages. But then we must also think about the other side of this bargain. So fishing for fools probably, so it probably has relatively little effect on us when we are aware of it. So the example of fishing on the computer serves us well here. Occasionally, occasionally one or another of us gets hooked in a fish. The estimates for the United States range from 0.6 million to 3.6 million per year. That presumably is enough to keep the fishers in business. I'm sure you get quite a few of these things in your computer. But compared to say the number and cost of auto accidents, this is probably something that's relatively minor. Why? Because we now know about computer fishing and we guard against it. We have all kinds of ways, including not opening the thing which tells us that we just won the prize in Ireland that's going to give us $200,000. So it's a minor's nuisance. But what happens if we ignore the fish? The example of fishing on the computer, yeah. What would happen if we denied it? Because that was a part of our constitutional psychological makeup. Or what would happen if we denied it? Because we've been sold a bad bit of intellectual goods. What would happen if we denied it? Because we were sold a bad bit of intellectual goods which said the free markets like the internet always invariably give us what we want because we are free to choose. Then fishing could have a major impact and I'm going to give you three examples. So the first example comes from health. In the United States, three quarters of all adults are overweight. Yet worst, a third of us are not just overweight but obese. Well, does the market help us with this problem? Well, maybe it does a little. So how would it help us? Well, we can go to Weight Watchers. We can drink Diet Coke or even Diet Pepsi and we can go and eat vegetables. Now that's some help for all of us who are concerned about our weight. But go to almost any mall, any place in the country and there will be the smell of those Cinnabons. There must be a mall near here where they have Cinnabons. And those Cinnabons are waiting for you. That smell like a moss pheromones is a call. It's a call to all of us overweight obese people. It is doing a fish for fools. Now between 1970 and 2003, the U.S. daily food calorie intake increased by 23.4%. And 480 of the 523 calorie increase, that was all in unhealthy foods. That is, it was in fats and oils, grains and sugar and sweeteners. So Cinnabon is only an example but it's also a metaphor. It's a metaphor for the temptations that the market is going to strew in our path. I'm going to give you two more examples. People save too little because they're constantly tempted and we're going to come back to this later in detail. An example three is the Great Recession. The Great Recession was caused by fishing for fools and as I said, we'll come back to that and see it later. So what are the general consequences? We've cited just three examples of the consequences of fishing for fools and the perils we run if we ignore it. And what this book will do is it will explore these examples in much more detail and it also explores many others. So now I'm going to go through some of the chapters in the book, or at least in the manuscript that I'm currently writing. So the next chapter, I'm going to skip the next chapter. It just describes the advantages of the fishers relative to the weaknesses of the fools. So it tells you why sometime this fish happens to be caught. There are a lot of fish swimming around the sea and there's only a hook here and there, so most of the time the fish don't get caught. But the fishermen, they're smart and they're smart, they're us people and they occasionally catch a fish and so the poor fish do get caught. Okay, so that's what that chapter is. So now I'm only going to summarize chapter three. So chapter three describes the history leading up to the Meat Inspection Act of 1906 and the Pure Food and Drugs Act of the same year. So what this history allows us to see, it allows us to see a world in which there was a great deal of fishing for fools. And it can be summarized in two pictures, so I'm going to give you two pictures. The first is the label for Swames Panacea. And Swames Panacea, you can see the picture, I think you can, gave a promise to cure almost every illness. Anything that you could think of that you have, you would want to go to Swames, at least according to the bottle. Well, it didn't do so well, instead it contained mercury and it killed people. But I guess you had one consolation, if you took Swames you would have Hercules, that's Hercules up there. Slaying some snakes on the Gorgon's head, I think, and you would have had Hercules on your side. Well, later in this entry if you decided you didn't want Swames you might go to Radham's Micro Killer. Now Radham's Micro Killer wasn't as bad as Swames because it contained water and dilute muriatic acid. I think dilute muriatic acid is nowhere near as bad as the mercury. So it probably had relatively few bad side effects. But it was useful because it made Radham, who had been a gardener in Austin, Texas, a fortune and he had, he got a wonderful mansion on Fifth Avenue in New York. Okay, so this just indicates, you know, if people say that, you know, you should just be allowed to be free to choose, there should be no regulation, this tells you, just go through the history. The history tells you when we didn't have regulation of this thing, people were buying Radham's and people were buying Swames. And, you know, these things like the food and the FDA and the meat packaging act, they really have done a lot of good. And let's not forget. Okay, now let's go to somebody else. Okay, so this takes us to the next chapter. Probably most everyone here knows who Susie Orman is. So when I asked an economist friend of mine about her, he had the predictable reaction. So this is what he said. He said he'd watched her for only 10 seconds and he could not stand her mommy knows best voice. He found her investment advice simplistic. And that's what most economists will tell you, you know. But then that means, but there's a puzzle. Okay, there's a puzzle that it does not explain why Orman's audiences are there lapping her up. So her most popular book is the following. It's the nine steps to financial freedom, practical and spiritual steps so you can stop worrying. Okay, so let's contrast what she says tells us there with the portrait given of consumer spending in the economics textbooks. Probably your economics textbooks here tell the same thing. I think it probably does. So according to economics textbooks, we decide on our demand for the proverbial apples and oranges by having a budget for our spending. And then we choose the combination of apples and oranges that we can buy that's going to maximize our happiness. But Susie Orman's financial advice books tell us the consumers do not follow such a textbook protocol in their purchases. Now, one question as an economist is how could a consumers do anything other than what the textbooks describe, you know. It seems to me, you know, I've been an economist for a long time. It seems to me almost impossible that anyone could do anything different. But in fact, people do. Orman tells us that people have emotional hang-ups with regard to money and with regard to spending it. And she says also that people are not honest with themselves. And as a consequence, they do not engage in rational budgeting. So how could she know this? How could she know something that economists don't know? Well, she's a financial advisor and with her various customers, and Clientel, she has a test. She asked her advisees to add up their expenditures. And those expenditures all but invariably, they all but invariably fall short of what a documented accounting from the records later turns up. So what is happening figuratively? So figuratively, relative to that proverbial trip to the supermarket to buy apples and oranges, this is what the people are doing. This is what her advisees do. They spend too much time in the fruit section buying all those apples and oranges. And by the time they reach dairy products, there's nothing left over for the eggs and the milk. In real life, such budgetary failure translates into having nothing left over for savings. So this failure to deal cognitively and emotionally with money says Orman leads to those unpaid bills. So it's her mission. It's her mission to keep those bills down so that her readers and her clients will not worry at night. So that's the role of mommy and also why those audience tolerate that mommy knows best voice. And I think it's worth noting, it's worth noting more than parenthetically that worries as noted in Orman's subtitle are central concerns of the financial advice books. But I think you can look up in the index of any economics book and you're not going to find it says the word worries. I looked, I tried to find it, at least in econ one books and I couldn't find it. And I don't think you'll find it in the intermediate books either. Okay. So we do not just need to take Orman's word for it, we can put together a statistical story which indicates that a very significant fraction, a very significant fraction of consumers are worried about how they're going to make ends meet. So now I'm going to give a statistical portrait that indicates that there's some merit to Orman's arguments. Okay. So a paper by Anna Maria was already asked the following question. How confident are you that you could come up with $2,000 if an expected need arose within the next month? So almost 50% of U.S. respondents replied either that they could not or they probably could not come up with the needed $2,000. The same difficulties regarding finances can be gleaned from the survey of consumer finances. So in 2004, according to the standard survey source from the Federal Reserve, the bottom half of all households had an average net worth of $23,000. Of that, a rough accounting indicates an average of only about $10,000 in financial assets. And then of course, most of that money in financial assets is going to be further tied up in some kind of pension fund that's going to be difficult to draw on. Divorce statistics give a similar picture of divorcing couples. So we have passed data on divorcing couples and that showed that their average value of assets was less than $25,000 in inflation-adjusted dollars. And remember, these data on the divorcing couples, they were from the divorcing couples where the divorce went through the courts. So these are actually the richer couples rather than the poorer. Now, we got a similar picture from data on expenditures relative to payday. For workers paid once a month, their expenditures are down a remarkable 20% on average by the time they're about to receive their next paycheck. And then we have one more statistic, then we have the number of bankruptcies. So by my calculation, there's something like a 20 to 25% chance that swindlers in the United States will go bankrupt over the course of their lifetime. So this gives a statistical picture which shows that, yes, people do have a problem saving. So this poses a problem. So the Susie Orman view of the world suggests that people are spending too much and they're worried as a result. And that leads to a question why. So there's another perspective. So we go back to 1930, John Maynard Keynes wrote a short essay. He wrote a short essay on what life would be like for our grandchildren 100 years later, presumably in 2030. Now, in one respect, Keynes was totally correct. He predicted that real income would be some eight times higher. So far, income has increased by six times and so he's right in target for 2030. But in other respect, Keynes was totally off the mark. He did not predict that the grandchildren would be going to bed worried about their next shilling. Instead, he said they would be worrying about how to use their surfeit of leisure. He said the work week would fall to 15 hours. Furthermore, Keynes failed to predict the housewife who exhausted from the first and then what is called the second shift. But the perspective of this book coupled with listening to Susie Orman gives us reason for this. So we have reason why people seem to be living lives of quiet desperation. So what's the answer to the puzzle? So in the United States, the goal of almost every business person is to get you to spend your money. There are few businesses actually out there which want you to save your money, but most of them are really to get you to spend your money. So I just think about life is a proverbial trip. It's a proverbial trip to a parking lot in which you're constantly passing those spaces left over and for the disabled. So life in a capitalist economy is just a continual temptation. So I just think about it. Walk down any city street. Those shop windows are literally there to make you come in and buy. That's what they're doing. They want you to come and buy. They're not there to tell you to stay out and save your money and go home. You're supposed to come in and buy. And there's even a nice song about it. This is actually one of my favorite songs. I don't know whether I should sing it to you. I don't think I will. So how much is that doggy in the window? They put the doggies in the window. Those cute little things. They don't put the parakeets in the window. And you go past and you say, yeah, that doggy is so cute. And you go back to the song. That song is really outrageous. The girl who sings this song, you know what she's going to do? She's going to go and she's going to buy that doggy. And what she's going to do with the doggy, she's not going to take the doggy home. She's going to give it to her boyfriend. And she's going to leave for California. Leave the poor guy with the dog. That's the story. But this is what capitalist economy like. In the shopping mall, one does not literally down the street looking in the windows. But there's temptation on either side of the aisle. And all of that tension is there asking you to buy. Actually there are whole books telling people who run stores about how you arrange those aisles to get people to buy more. It's no coincidence that the milk and the eggs are in the back. And it's no coincidence that the candy is right there when you're going to leave. Okay, so this is what things are all about. No matter what kind of transaction you are, the people are getting you to try to buy. So that's what we are. So consumer advocates are worried about credit cards and their effects. And there's good evidence. I think there's good evidence that credit cards lead people to spend more. But the idea of getting, tempting the consumer to buy to spend her money is much more general as in the very nature of free market capitalism. Okay, so this is a very general message. And this is just the nature of the society in which we live. So that's Susie Orman's show that we all thought was so annoying. That's just, that's no coincidence. That as much as those stores that we pass, that is part of the system we live in. And so we should, I don't know if we should accept it, but it's part of what we do. The financial crisis. Okay, so now I'm going to talk about the financial crisis. I'm going to talk about it in very few words. But I actually think maybe, you know, you can say lots of complicated things about the financial crisis and they'll all be true. But I think I'm going to try to go to what I think is the essence of the financial crisis. So there are hundreds of books on the financial crisis. And the typical one is 500 pages long. And I haven't read hundreds, but I've read many, many. And the typical book tells the story of my institution. Say, if somebody who was at Lehman Brothers, or somebody who was at Goldman Sachs, or you have one on Fannie Mae, Freddie Mac, or you have one on the Fed and one on the Treasury. And the story of every book is my institution, the one I'm writing about is central to the crisis. Okay, so the aim of this chapter of this book, Fishing for Fools, is to do the opposite. The aim of this chapter is to tell the story of the crisis in general terms. So you scratch any economist and we're going to go into economics speaks. So we're trained to think in terms of supply, things like supply and demand. So that means that we often ask very good questions and have good analyses of problems. So Fishing for Fools is an offshoot. It's an offshoot of how we standard economists typically do our analysis. But it turns out it's not so standard. It's not so standard that every economist was asking the right questions in the buildup through the crisis. But we should have been. Why should we have been? Because Fishing for Fools gives us an extremely succinct explanation for what happened. So let me give you just one rendition of that. So here's that rendition. Okay? If I have a reputation, if I have a reputation for selling perfect, beautiful avocados, I have an opportunity. I can sell you a rotten avocado at the price you would pay for the perfect ripe one. So I will have mined my reputation and I will have also fished you for a fool. Okay? So such a story lies at the heart of the continuing financial crisis that dominates the economics of our times. The reputation mining in question involved the subversion of the system for rating fixed income securities. So let me give you a bit of a story. So the reputations of Moody's and Standard and Poor's had been built up over the course of almost a century. Their job, their job was to rate bonds on their probability of default. But then in the late 1990s and the early 2000s, the ratings agencies took on themselves the task not just of rating bonds, but also of rating more complex derivative securities, packages of bonds and all kinds of complicated things. The complexities of the payment structures made them somewhat hard to rate, but something else made the rating all but impossible. The underlying assets, such as mortgages, were inaccessible to the raiders. So even if you wanted to do so, it was all but impossible to do so. But the public, the public out there would believe whatever ratings were given on them by the agencies. And then an industry grew up, an industry grew up simply to do a reputation mine. Okay? So what happened by analogy? By analogy, rotten avocados were being labeled perfect, and with that label they commanded premium prices, and a whole central valley full of growers went into the profitable business of producing such avocados. This mining of the ratings is then the basic story of the financial crisis. So I'll give you a little bit more, I'll tell you just a bit of detail, but that's really the basic of what happened. So that's not all of the explanation. We may also explain why the production and sale of those overrated securities brought down the financial system. So I guess it would be okay if you bought one of my bad avocados, you know, and you take it home and throw it in the garbage or whatever. But in the case of these rotten securities, something bad happened further. So the answer, again, is simple. The value of these securities reflected their ratings. That enabled commercial banks, investment banks, and also hedge funds to borrow huge amounts of money, short term, invest in the overrated securities, and pocket small profits from the interest spread on every dollar of investment. And in doing so, they all took on a lot of leverage. That borrowing was made with the rotten securities as collateral. So basically what these people did was they took on these terrible avocados and then they went to the bank and borrowed on them. And they were able to borrow them because the securities agencies had actually said they were great avocados and the bank says yes. So that borrowing was made with the rotten securities as collateral. And for the moment it seemed to be as good as gold, the ratings indicated there was almost no chance of default. But then of course we all know the truth was discovered and those avocados perfect as they were on the outside were really rotten on the inside. They were worth much less than the bankers and finance managers had paid for them. So what did we find? We found from Frankfurt to New York to Reykjavik that financial institutions owed much more than they owned. And without bailout they were going to be bankrupt. And that's what we're finding and that's what the continued story is of our time. So just to give you a summarized summary of the chapter, the chapter answers four questions. The historical answers to these questions. How would the ratings agencies initially establish their reputation? What then changed making it more profitable to mine that reputation than to keep it? Why were the buyers of those rotten securities so naive? And why was the financial system so vulnerable to the discovery that the assets were so rotten? So that's basically my story. I'll give you a list of the future chapters of the book. Actually I've written all the conclusion and the looting chapter. So this is what the rest of the book is like. And each of these chapters I hope is fun. It's fun to write the advertising chapter, the lobbying chapter, socialist economies chapter. So let me just give you a summary. And now I have to skip to the end. So I'm skipping. So now I come to the conclusion and let me see what I have to say about the conclusion. So I think the first part of the conclusion is the following, that fishing for fools is important. The second is that it creates bad equilibrium and it does so especially so if we think markets are totally benign and if we ignore the fishing for fools and the role that markets play in that. So thank you. So shall I take questions? So let me take questions if there are any questions. Yes. Why don't you stand up? Oh, I'm sorry. I'm sorry. I'm sorry. I'm sorry. No, no, no. Okay. So I'll try to repeat your question. Or speak loudly. Well, the ratings agencies are supposed to do a rating. They used sort of standard economic models to do this. And I think the way to put it is the people whose ratings were the investment houses. So that was the change. Previously, Moody's and standards are poor. What they did is they published books, expensive books, which your library might have to buy, especially if it was a business library. Then something like in the 1970s, for the first time, Moody's decided it was going to take payment for these things. Now, the thing is the ratings agencies. So the answer is what you say is true. But the ratings agencies had no incentive to behave in any other way. So any person in the ratings agency who would say, gee, we're only thinking that house prices are going to go down. They're going to go up. So these mortgages are all going good. What do you think would happen to that person? That person was going to be fired. First of all, how was that change going to work? We'll take some investment house that's trying to sell this package of bonds. If this guy comes and says, gee, I don't think those bonds are so good. I think we shouldn't assume that those prices are always going to go up. The investment house which is selling that package is going to say, gee, I'm not sure we want you to be rating our agency. We'll go to the other one or we'll go to some other advisor. Now, you take the person farther down the list, the person who is going to make this wisecrack suggestion. That person is going to know that it's not in their interest. So in this sense, the ratings agencies were fishing for fools. So they weren't directly fishing for fools. They were at the end of this chain in which they were going to fish for fools. So then what happened, so then once you had these bad ratings, then in fact, I'm going to use my word intentionally. Then what that did is that metastasized to all kinds of other areas of the economy. So you had this one very basic misalignment, but then the trouble was that the economy was in such a way that with this misalignment, you could get this terrible metastasization that then affected the rest of the economy. All right, so I have an explanation for it. So you go back to the 1920s and you can find the same thing. And you go into the history of, let's say, Goldman Sachs. So Goldman Sachs sold some things that were probably worse than anything that anybody was going to buy today, although maybe that's an exaggeration, but they sold some very, very, very bad things. But then the investment houses went into a different mode of operation. Actually, they reverted actually to their previous mode. So what are the investment houses supposed to do? These guys were supposed to be underwriters. So you own some nice company, Chrysler will say. And you have to float, you have various financial deals that you need to do. So what do you do? You come to New York and you come to Goldman Sachs. And I'm your friend. You're my client and I'm like your lawyer. I tell you what to do. So what is my business? My business is to be your friend and to give you nice advice and you're my client. And then occasionally what you're going to do is you're going to be nice to me since you're my friend. And in return for this advice you're going to let me float your bonds which will occur or some kind of stock issuance. So basically I'm in a very, I'm in a different, I'm in position of being your fiduciary, your advisor, your lawyer. Your advisor and your lawyer does not want the ratings agencies to be going out and misrating the bonds. And so at this point the interest of the investment houses was to police the rating agencies. But then life changed. How did life change? The investment houses found that they, that there was much more money to be made relative to the client business to be made in terms of their own trading. And so once they became traders with a D, they, once they became traders the ethics changed. And actually one can see this. There's a document in the history of Goldman Sachs. So there was a, there was a director and then let's say, I think this is dates probably since the 1970s by the name of John Whitehead. And he was worried about the fact that the ethics was changing. And he, and he wrote a set of 15 principles for Goldman Sachs to follow. And these are the principles that Goldman Sachs does follow. It begins, the first principle is the customer should always come first. So that's the, so, but, but he was worried about this. He was worried about it because he saw the changes that were beginning to take place in the business. And he was worried about the changes in ethics. And I guess maybe those changes in ethics did come about. And, and that's what we see. Yeah. Okay, so the initial story was, so you got exactly what the story is. The initial story was that people see the trade is minus P over four and therefore there's no trade at all. The people, they just stay out of the market. There's no loss in welfare. I'm stupid. I'm naive. I don't know that they're going to be these people doing adverse selection. And so then I come into the market and then I get jipped. And so I get jipped. I go along and life goes along and I get jipped. I buy these bad cars and then suddenly, you know, I come in and I say, God, what have I done? I bought these bad cars and then I stop and say the economy crunches to a halt. Now, what makes that worse is I bought the, not only five bad, the bad cars, but I go into the bank and bought that bad cars. And so not only, I'm, I'm, I'm wiped out. I don't have my car anymore. And furthermore, I don't know the bank is bankrupt because it's made me this bad loan for which I put up the bad car. So that, I think that's the answer to your question. You mean how did we get there in the first place? Oh, okay. That's a very good question. I think most of the thing is, it's, okay, so I think, I think that's actually the last, I think that's interestingly, I think that's, that's equivalence of the last question. How did we get there? So, okay, so I'll give you a little bit of economic history, which is, so we went through the, we went through the 1920s and there was this fishing for fools. Then what happened after that fishing for fools is that we set up, I think, good regulation of the securities industry where, in fact, it became quite difficult to fish for fools. We then let, then something like 40 years passed, the, during those 40 years, it turned out that the investment houses saw that their interest was to be honest, not to, not to fish for fools. So the economy grew during that time. And then, in fact, then we have this, then, in fact, because, because the, they see, we have these new ideas and people see you can sell all of these derivative securities and you can, and these, you have some kind of, some kind of metastatization in which, in fact, you get, you get this new, these new ideas, but they turn out not to be good for you, they turn out to be bad for you. Okay. No. Okay. Can I, can I answer it? Okay. Um, yeah, I think the people really believe this. I mean, the people really believe this, the people bought these assets. They didn't see that there was going, it goes exactly to the model that we had at the very beginning. The people do not see that there's going to be this adverse selection in which the mortgages that are going to be produced are going to be these bad avocados. That somehow, that if you get a false rating there, people did not know that there was going, there was this false rating. And then once there was a false rating, I mean, think about this, if I can, if I can sell rotten avocados, they're probably much cheaper to produce than good avocados. And so what's going to be produced with perfect markets, you're going to get infinite supply of those bad avocados. No, no, I don't think that I, I, well, okay, so the question, some, okay, the question is Wall Street people, you know, it's a big chain. The people, okay, so I think there's, okay, so the people in California who are making the bad mortgages, there's no question they knew. That's, they must have known. The script for how the salespeople were supposed to go out in the way the contracts are written, those people knew. Then what you do is you go through some kind of long chain and at the end of those chain, the people who are supposed to be the buyers of that, they are the buyers of the lemons and they don't know. So the whole thing was that you're supposed to take this bad avocado at the end, you send it to, you send it through a big chain in which you put, you put a lot of wrapping on it and wrap it in fine paper and then the buyer's not supposed to know. So going through Wall Street, put it into fine paper and, and, and hid the fact that these were bad avocados. And who, what was, what was the wrapping on those avocados? The wrapping was of course the ratings. So, you know, you didn't even need to look it. Yeah. Yes. Yes. Yes. Say, speak louder so other people can hear. The people, free markets going to be sold. So there were even, there were government officials, high government officials who said that economic, that free markets would be sold. The thing is that, that the SEC did put in effective, effective regulation as of the 1930s. But then it was just ignored and it was just assumed, then we went into an ideology where it was believed the free markets would just be benign. And that's what this book is aimed at. This book is aimed at saying, no, we, so this book is aimed at saying that, this is something that's automatically going to come out of market systems because market systems don't just produce what's good for me. That may, they may produce that most of the time. We have this nice building here and we have pretty nice slides. But sometimes, and it could be very important, the markets going to produce what's bad for me. And so, so the thing is market, the whole idea of this book, so there are many, many examples in economics since you can go into finance in which the people are naive, they lose out. But the trouble with these examples in the way that economics is written and taught is that each of these examples appears to be just in this special situation. We should appreciate the fact that markets are going to take advantage of people if they're not wearing it as a very important fundamental principle in economics. And so, it isn't that every economist wouldn't agree with this, it's just that we ought to put ourselves in the mode that we know we're careful. So when you open your computer, when you open your computer, you're careful, I'm sure you are. And so this just says that we've got to put people in the mode where they're going to be more careful and they're not going to buy these rotten bottom packages. Hi, I'm just curious, one of the fundamental underlying principles of free markets is that they aim for your weak spots, weak out, emotional and cognitive weaknesses, block current channels of information and play on the fact that what we don't know, we don't know. How is it possible to be an aware consumer and not naive? I didn't mean for the last thing. How is it possible to not be naive? If this is to take money off fishing, how can you not be fooled? Well, I think... Okay, so the thing is we're very smart and we're trying to always look out. But they're very smart and they're always trying to fool us. So sometimes we may win most of the time, but sometimes we're going to be naive. And so some of the time we're actually going to be successful in there being a fish. Remember, so that was the chapter I skipped. So the idea is that the question is what are the advantages of the fishers and what is the weakness of the fools? One of the advantages of the fishers is that there's so many of them. Every one of us can be a fisher and there may be a smart one, just a very smart one. And then also the thing is that every one of us, most of the time we're going to be smart, but some of the time we're going to have weaknesses. And so then we're going to be fishers. So they're very big space of a fisher and they're very big space of our weaknesses and they counterbalance the fact that we're also very, very smart. And that's the answer. If you look at the one you made off, is it a scheme or a scam? Were there any smart people in the scheme of things at all? Okay, okay. Well, Ily Wiesel, for example. Yes, I actually know, surprisingly a number of people who are either connected or actually were fishing by Bernie Madoff. So I guess he would manage to have some kind of persona where people thought that they could invest their money with him and they'd win. So that's an example. That's a very good thing. The idea of a ratings agency, a rating agency, sounds like a slippery slope. So is there a way that you can establish credibility for rating agencies like external to them or do we just kind of have to figure it out? Well, the ratings agencies should have been supervised by the SEC. The SEC was responsible for their regulation. The SEC should have been on this. But the thing is, that's unfair to blame the SEC because one of the chapters that I didn't cover about lobbying, there's a great deal of lobbying to keep down the money that goes to the regulators and especially the SEC. So the fact is that we're not putting the money that we need to. So this is another answer to your question. We as a public are not sufficiently wary about these things and we're letting the people who have an interest in keeping the regulation down to get their way. So the SEC has blamed a lot. But the SEC has not given the sufficient budget to do what they need to do. So when you were talking about health and Cinnabon as a metaphor for a rising disease, it made me think of low income neighbourhood and how a lot of times they have to move fast food chains because of lack of access to grocery stores and lack of affordability and all these other socioeconomic factors that limit their choice. So then are they being fished or are they subject to their socioeconomic status? Okay, that's a good question. I feel if you have a tougher life, it's easier to fish. You just have more cognitive things on your plate that you have to deal with. So there's a book being written by Eldar Shafir and Sendil Mohamed. It shows that people under stress tend to make bad decisions. It seems to me if you're under stress, it's much easier not to go out and eat the Cinnabon, for example. It's much easier to get into what would be called a temptation. In this case, they know that vegetables are more healthy for them but they just do not access them far they can't afford them. So what are these people who know that it's bad for them but they just don't have... Okay, well that's... You see, that would be a... So that I would classify as a separate problem. I'm not telling you every problem in the world is going to be fishing for fools. But the thing is the Cinnabons that smell that gets you and then you go and buy the Cinnabon, that's definitely efficient for fools. But the free market is not helping people choose the things that are good for them. They're not getting an incentive to do that. They're getting an incentive to go and whatever the free market wants to sell them, whether that's calorific or not. Okay, so that's... I can believe there's also worse to be low income. I've always believed it was bad to have low income and that's also a further problem. That's one chapter... I think regulation is difficult. I think regulation is very difficult, especially in this type of market. And so the fact is it seems to me that just because the regulations may be difficult doesn't mean that we shouldn't have regulations. So the fact is I take the example of Cinnabons. What do you do about the Cinnabons? The fact is I'm not sure I know what to do about the Cinnabons. Maybe there should be a regulation that they're not allowed to have, they're supposed to have chimneys so the smell doesn't go out into the mall. But I think in each of these things you've got to look at it in a case-by-case basis. So in the case of financial securities, it is just crazy not to have a very high level of regulation of financial securities and also having people who look over financial securities and give an independent evaluation. The fact is part of the message of this book is that you have this problem. This problem isn't like the standard economics where you have an externality and you can just put a tax because this stuff is really interwoven into the economic system and the same forces which are going to give you the benign thing, which is what we want, are going to give you the malignant thing. So when you deal with malignancies, you have to use your judgment as to exactly how far you're going to go. So you're going to need the regulation but you should also be aware that this is regulation which is going to be very difficult and going to have side effects. And so what you do is you don't go to some kind of person who says, no matter what we should be free to choose, you have to use your judgment as to exactly how far you go. You've got to look at the positives and you have to look at the bad side effects. Now that may be a long story but the thing is this is a very different view than what you're going to learn from most economics textbooks who say, everything's an externality. These things aren't externalities. Instead these are things that are ingrained exactly into the economic system. And so any regulation you're going to put in is going to have side effects and you have to weigh it. And that's what we do. That's what a lot of medicine is all about. A lot of medicine is you have this terrible procedure and you have to weigh the terrible procedure against the fact if you don't do the procedure it's going to be worse. So thank you all for one second, please.