An Interview with Edward Conard
Edward Conard is a top-ten New York Times best-selling author of Unintended Consequences: Why Everything You’ve Been Told about the Economy is Wrong and a visiting scholar at the American Enterprise Institute. After earning his M.B.A. from Harvard Business School, Conard worked at Bain & Company and Wasserstein Perella. He was a partner at Bain Capital from 1993 to 2007 and headed Bain’s New York office starting in 2000. Conard received national media attention in 2011 for a then-anonymous contribution of $1 million to a Super PAC supporting the campaign of Mitt Romney, his former partner at Bain Capital. Conard currently sits on the board of directors of Waters Corporation.
The Politic: What do you see as the current direction of the economy?
There are two kinds of recessions. The most common recessions stem from temporary Keynesian-like lulls in demand. The economy declines briefly and then rebounds back to the prior trend line.
A temporary lull in demand can cause permanent damage to the economy. Displaced workers may never regain their prior productivity, for example. Keynesian stimulus attempts to temporarily inflate demand to avoid such displacement. It sacrifices long-term growth for short-term growth.
The second type of recessions, which are rarer, stem from permanent structural problems. Demand declines and grows from a permanently lower base, never rebounding back to the prior trend line. The economy can still achieve full employment but at lower wages than would have been the case had it rebounded.
Where the decline in demand is permanent, displacement is unavoidable. Keynesian stimulus becomes an expensive bridge to nowhere. Under these circumstances, a more optimal economic policy maximizes long-term growth.
Most of the arguments for Keynesian stimulus implicitly assume this recession stems from a temporary lull in demand. They often cite historical evidence, but most all the historical evidence is from recessions that stem from temporary lulls in demand. Advocates of Keynesian stimulus rarely acknowledge the difference between recessions that stem from the temporary lulls and permanent structural problems.
I believe the financial crisis exposed structural risks in our economy that we underestimated prior to the crisis. We assumed implicit government guarantees, which stand behind our banking system, mitigated the risk of bank runs because there hadn’t been a major run on U.S. banks since 1929. Despite the Fed’s successful intervention as the lender of last resort, we now realize there is much more risk of damage from bank runs than we realized. As a result, the economy has dialed back risk-taking in other areas to offset this now-recognized risk.
In my book, I predicted that fiscal and monetary stimulus wouldn’t have much effect on the recovery or cause inflation if we failed to mitigate the structural problems exposed by the financial crisis. We have not mitigated these risks.
The Politic: In your book Unintended Consequences, you criticize efforts to increase bank regulation as slowing risk-taking. How can the United States avoid another Financial Crisis while decreasing oversight?
In the book, I call for charging banks for the inherent guarantees governments provide to depositors, thicker capital adequacy requirements, and regulation to increase transparency. Nevertheless, I criticize the philosophy of eliminating “too big to fail” as failing to address the structural risk inherent in banking.
Consider a simple corn economy. We can eat the corn, plant the corn, or store the corn in silos. If we eat it or plant it, the economy will grow. But if we store the corn in silos, rather than eating or planting it, the economy will grow more slowly, unemployment will be higher and wages lower. In a recession, for example, people get scared and hoard rather than consume or plant their corn. Banks take corn out of the silo and loan it to consumers who eat it or to famers who plant it.
Bank can go bankrupt in two ways: by making loans that borrowers can’t pay back and from a run on the banks. It is important to separate the two. We must hold banks 100 percent responsible for bad loans. If we don’t, banks will make unproductive loans with our savings.
Bank can also go bankrupt from withdrawals. Unfortunately, risk-averse savers would stuff their silos with corn were it not for the right to withdraw their deposits from banks on-demand. But there are no investments like that in the real world. If you build a home or a factory, it could take 30 years to pay back the corn. The deposits have been loaned and cannot be retrieved except over long periods of time.
As a result, banks are inherently unstable. If depositors panic and run to the banks en masse to withdraw their savings, banks must sell assets to fund withdrawals. With heavy selling, assets values sink to fire sale prices. Banks cannot sell enough assets at those prices to fund the withdrawals. Under those circumstances, withdraws logically cascade to 100 percent of deposits as depositors race one another to withdraw their savings. The network freezes and the entire banking system is rendered insolvent.
This problem is well understood by economists. But prior to the financial crisis, we assumed implicit government guarantees standing behind our banking system mitigated this risk. We were mistaken. We now recognize the risk of damage from a run on the banks is much larger than we realized. The economy has dialed back to compensate.
Most of the measures in Dodd-Frank do little to mitigate this risk. In fact, it makes it harder for the Federal Reserve to intervene as the lender of last resort to end a panic by politicizing the Fed’s intervention. It increases rather than decreases the risk of damage from a panic.
Preventing banks from becoming too big to fail allows us to liquidate banks that make bad loans and fail in insolation. We can sell their assets to other solvent banks. But in a panic caused by a systematic shock to the economy — a 30 percent drop in real estate prices, for example, which affects all banks — it doesn’t matter if banks are consolidated or fragmented. Depositors can and will withdraw from all banks regardless. Eliminating banks that are too big to fail does nothing to reduce this risk.
Worse, if we hold banks responsible for funding withdrawals in a panic, they have no choice but to leave deposits sitting idle available for withdrawals rather than lending them to build homes and factories that increase productivity, raise standards of living, increase wages, and lower unemployment.
If we fail to mitigate this risk, our economy will grow from a permanently lower base. Charging banks for the inherent guarantees governments provide to depositors, increasing transparency to price those guarantees more accurately, and increasing capital adequacy requirements to reduce the risk of subsidizing loan losses are steps we could take to reduce the risk of damage to our economy from bank runs.
The Politic: Should any reforms be made to banks?
Taking risk-averse savings and putting them to work, which is critical to growing as fast as we can and creating as many jobs as we can, is highly unstable. To minimize unemployment and maximize growth, we have to live with this instability.
The cheapest way to minimize this instability is for the government to guarantee banks from going bankrupt from panic withdrawals, but not to guarantee banks from losing money from loan losses. Separating those two in a panic is very difficult. The reason risk-averse savers are running to the banks to withdraw their deposits is because they are concerned banks may lose money on their loans. Larger capital adequacy reserves protect the government from extending its guarantees to loan losses. But when there is a systematic panic to the whole system like there was in the crisis, we want the Federal Reserve, as the lender of last resort, to step in and do exactly what it did. Instead, we have mistakenly blamed the Federal Reserve and the banks as opposed to recognizing that this is an inherent instability that we live with.
The Politic: Why should the subprime mortgage industry and Wall Street practices not be held responsible for the Financial Crisis, as many people suggest?
Obviously, those factors contributed, but with a 30 percent drop in real estate prices, it is likely a run on the banks would have occurred even with conventional 20 percent down payments. And contrary to popular belief, in effect, banks found subordinated lenders in mortgage securitizations to make down payments on behalf of homeowners.
Some critics claim government policies that subsidized housing are responsible for the rise in U.S. home prices prior to the crisis, but home prices rose similarly in countries that did not have these polices. Rising home prices were more closely correlated to countries that ran trade deficits.
Blaming borrowing and lending puts the cart before the horse. The problem is an abundance of risk-averse savings — corn in the silos — that must be invested or consumed to achieve full employment. Putting risk-averse savings to work — savings, which demand no losses and on-demand withdrawals — is inherently risky and unstable.
On opposite ends of the spectrum, there are two kinds of savers. On one end are risk-averse savers who are unwilling to bear losses — corn in the silo. On the other end of the spectrum are equity investors who are willing to tolerate risk by bearing losses. To put risk-averse savings to work, equity must bear the risk.
Unfortunately, we have a surplus of risk-averse savings relative to a shortage of equity available to bear risk. For a variety of reasons, price does not equilibrate supply and demand. For example, risk-averse savings are, by their nature, price insensitive. Successful risk-taking, which largely produces equity, is taxed heavily by the government.
The trade deficit exacerbates this imbalance. When we buy goods from surplus exporters like Germany, Japan, and China, they end up with a surplus of dollars, which they must use to buy U.S. goods or assets. If they bought U.S. goods, trade would balance. Instead, they buy U.S. assets. Only countries with high saving rates and that are willing to invest their savings offshore can run trade surpluses. As risk-averse savers, Germany, Japan, and China predominately buy U.S. government-guaranteed debt. With a limited amount of government-guaranteed debt, offshore demand for this debt pushes domestic risk-averse savings into the private sector. This influx of risk-averse savings further destabilizes our economy.
There are huge institutional markets of risk-averse savings. Like corn in the silo, that money would sit idle were it not for money center banks. Until we find an alternative use for these savings, we will not return to the pre-crisis trend line. A solution requires figuring out how to invest risk-averse savings productively with minimal risk. So far, we have not found a viable alternative use for these savings.
The Politic: Why should people feel comfortable taking risks in order to innovate when there’s such a high chance of failure statistically?
Innovation is like any game of chance; poker, for example. What causes you to play a round of poker? You look at the pot, you look at your hand, you ask, “What’s the value of the pot and what’s the probability of me winning the pot relative the cost of continuing to play?” The chance of successfully innovating and capturing the value as profit is very low — perhaps one in 100 — so the payoffs need to be large to motivate the optimal level of risk-taking.
Do I think it’s perfectly linear? No.
The Politic: How can society incentivize risk-taking?
The most obvious way to increase the payoff for risk-taking is to lower the taxes on successful risk taking. To do that, we need less government spending.
With a shortage of risk-taking, more risk-taking produces a self-reinforcing feedback loop that increases the payoff for risk-taking. For example, successful risk-taking produces industries like those surrounding Google and Facebook that provide our workforce with more valuable training. That training increases their chances of success. Successful risk-taking also puts equity into the pockets of investors who are then more willing to underwrite the risks that produce innovation. It’s not as though European growth would immediately accelerate if it cut its tax rate. Because of these self-reinforcing feedback loops, it would now take decades of innovation to build the industries and work experience necessary to grow faster.
The Politic: With so much value placed on investment, what is the place for philanthropy in society?
People are merciful and charitable. We don’t want people to suffer. Most all of us are willing to pay for less suffering. But we also need to recognize what is truly in the best interest of the poor. In many cases, investment is more beneficial than charity. In 1980, 50 percent of the world was living on less than $1.25 a day. Today it’s down to 20 percent. Has charity lifted those people out of poverty? No. Economic growth has lifted them out of poverty. Commerce is the salvation of the poor!
The Politic: In your book, you write that the increase in the income disparity is beneficial. What positive effects can be seen from the income disparity in the U.S.?
High payoffs for successful risk-taking indicate a shortage of risk-taking that produces innovation relative to the value of innovative discoveries. Those discoveries have produced faster growth, higher employment, and higher median wages. Since 1980, U.S. employment has increased almost 45 percent, from about 100 million to 145 million workers. Since 1991, the U.S. economy has grown over 60 percent. Against these same measures, France and Germany grew less than half as much, and Japan about half as much as France and Germany. U.S. median wages are 25 to 30 percent higher on a comparable basis. Without the success of the U.S. economy, the European and Japanese economies would have produced even slower growth.
The Politic: Some argue that the income disparity mostly benefits people at the top.
Let’s split the population by income into the top, the middle, and the bottom. What’s occurring in those three groups is very different. Let’s start with the middle. The U.S. has created 44 million jobs since 1980. Half of those jobs were created at the highest end of the wage scale. That growth also pulled 10 million immigrants into the U.S. workforce since 1996, when the Census Department started publishing statistics. Those immigrants received better jobs, health care, and education for their children. The U.S. economy also put tens of millions of people to work offshore. No other high wage economy has done more for the middle class and working poor.
Arguments to the contrary focus on the tepid growth of median incomes. Nevertheless, the total amount of middle class income has increased substantially because the number of jobs has increased substantially. There is an economic tradeoff between higher pay and fewer jobs or lower pay and more jobs.
Also, when you hear that median incomes haven’t grown, keep in mind that measure doesn’t include not-taxable benefits, healthcare principally, as well as pensions and government entitlements, which have grown significantly.
At the top of the pay scale, the income of the “one percent” is accelerating because of a shortage of risk taking that produces innovation relative to the growing value of the unrealized opportunities.
One constraint to harvesting that value is the supply of smart, talented people. The second is getting them properly trained. And the third is getting them to take entrepreneurial risks that commercialize innovation.
It’s ironic that my critics pigeonhole me as the defender of the one percent. I believe the talents of mankind are owned by mankind and not by the lucky recipients of that talent, and that the unrealized investment opportunities that lie before us are owned by mankind.
If everybody with talent was trained properly and taking risks that produced innovation, I would say it’s morally wrong that the lucky recipients of talent should benefit merely from these circumstances. But I see many talented people that won’t get the proper training. They want to be psychology majors, for example, even though there’s a surplus of psychology majors. They see business and technology as tedious and boring. We can’t pay them enough to get the training and take the career risks needed to produce innovation. It’s their reluctance that sets the wage. We shouldn’t pay individuals one dollar more than necessary to motivate them to get the training and take the risks. It’s our talent and investment opportunity; not theirs.
At the other end of the income scale, I don’t think economics alone causes poverty. We’re currently in a recession, but even at full employment, we still had plenty of poverty. I do not believe the poor are lazy. I believe there are sociological issues — e.g. high rates of dropouts, teenage and unwed pregnancies, crime, and childhood neglect — that make it difficult for people to become as successful as they could be. Economics on its own won’t solve these problems.
The Politic: Is it not possible to increase the number of jobs without increasing the income disparity?
Theoretically, it might be possible, but empirically, we don’t see it. The other high-wage economies — Europe and Japan — have less income disparity but they have produced much less innovation, slower growth, and less employment than the United States. Our median incomes are 25 to 30 percent higher than theirs. Our hours of work per working age adult are in the range of 35 or 40 percent higher than theirs. It’s hard to look at that and say that we ought to mess with the U.S. model. I think the European and Japanese models show you how difficult it has been over the past two or three decades to grow income and employment in high wage economies. They’ve all fallen back to about 75 to 80 percent of our GDP per capita as we’ve spurted ahead over these last couple of decades.
The Politic: Many students are not sure if Social Security and Medicare as we know it will be solvent by the time we reach the age to qualify. What is the fix for entitlement programs?
Let’s not kid ourselves. Ultimately, economic growth determines the level of entitlements we will be able to afford in the future. The more growth we generate between now and then, the more we will be able to afford. The more we invest, namely to produce innovation, the faster we will grow. The more we consume today, the less we have to invest for tomorrow.
If I were a young person, I’d be for investment because I’d be for a better future. I’d ask older people to reduce their consumption and increase investment so the future would be better for our children.
I think politics is split between the party that represents consumers and the party that represents investors. The vast majority of voters are consumers. A small minority are investors. I believe the natural course of democracy, unfortunately, is to tax investors for the sake of increased consumption.
Republicans are really a coalition of two minority parties — pro-investors and the Christian Right — fused together out of necessity to create a near-majority. Pro-investors tend to be fiscally conservative and socially liberal. The Christian Right tends to be socially conservative and fiscally liberal.
Unfortunately, I think many idealistic young people are reluctant to join with the pro-investors because of their pragmatic coalition with the Christian Right. They end up supporting consumption over investment even though they are for investment. Ironically, that only strengthens the Christian Right’s negotiating leverage within the collation.
The Politic: Do you see value in a liberal arts education, as opposed to a more strictly pre-professional education?
Economically, the only thing I care about is what’s good for the poor and the middle class. All the rest of this stuff is a means to the end. The question is whether the poor are better served by humanities majors or technical majors.
The best way to help the poor is to grow the economy. If you look at the income per capita versus the income for the poorest 20 percent, there’s a very tight correlation between the two. America’s poor are much better off than China’s poor or Africa’s poor.
Over the past 20 years, we have differentiated ourselves through the commercialization of innovation, not through humanities. We need more people to find and commercialize innovative ideas that are likely 20 times more valuable than they cost. That’s what’s pulling the poor out of poverty. I think business and technology majors are more likely to do that than liberal arts majors.
That’s not say we don’t need any humanities majors. My wife is a novelist. Critical thinking is valuable in all of its forms. There are plenty of things we can learn from humanities and use to create value that’s truly valuable for the poor. Ultimately, we need a balance.
But in the end, commerce has proven to be the salvation of the poor, not charity. Talented people have a moral obligation to put their talent to work on behalf of mankind in the most productive way. There is hardly perfect alignment, but by and large people pay for what they want and need. For the most part, we serve our fellow man by serving customers as best we can.