John Cochrane on Growth and Why the Public Policy Debate is Like an Old Marriage

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EconTalk Episode #544 (Archive of all episodes, here)


(Conversation lightly edited for clarity and readability)

Russ Roberts: Today is July 28, 2016 and my guest is John Cochrane, Senior Fellow at Stanford University’s Hoover Institution. Before joining Hoover, John was Professor of Finance at the Booth School of Business of the U. of Chicago for decades, and along with his extensive scholarly output, he blogs eloquently at The Grumpy Economist.

He’s also a competition sailplane pilot, which means he races gliders. I have to confess that being 18,000 feet above the surface of the earth without an engine scares the heck out of me. So, John is both wise and brave. We are recording this episode in front of a live audience in a special event for Bay area alumns of the Booth School of Business of the U. of Chicago, many of whom have come out to see their former professor. Which is lovely. John, welcome back to EconTalk.

John Cochrane: Pleasure to be here.

Listen to the conversation on Soundcloud:

Russ Roberts: Now, our topic for today is how you, in looking at a wide array of policy issues, would like to reset the debate. Or reframe the conversation in public policy related to economic areas. And in particular one of the things you emphasize is that we have under-emphasized and really forgotten about economic growth. It’s not really getting any attention in this election cycle. No one’s really talking about it. And in fact it’s gotten to be a little bit, I think, even disparaged as a serious topic. And others would say, ‘Well, it doesn’t matter. We can’t do anything about it.’ So, let’s start off with the question: Why is it important?

John Cochrane: Let me back up to our two framing issues: economic growth and how do we step out of this frozen discussion we’re having that isn’t going anywhere and reframe the issues in a way that makes some actual progress along a wide swath of issues. If you think about the important issues of economic policy, economic growth is it. It just begins and ends at economic growth. Over the long run, 10, 20 years — we call that the long run but 10, 20 years goes by pretty quickly —just nothing matters as much as reestablishing or improving on the traditional growth rates.

The United States used to grow about 3.5% a year; now we’re down to 1.5% — 2% if we’re lucky. And the little percentages don’t sound like much, but they add up; and it means just over the 20–30 year horizon whether we double everyone’s standard of living, or we don’t. And whether we get the wonderful things — it’s not just more stuff: it’s better stuff — better health, better environment, ability to pay off the government’s debts, ability to pay for our social programs — really just everything hinges on economic growth. And especially compared to the other things that are being talked about, more growth solves all of those problems. And it’s just a much bigger issue than all of those problems.

Russ Roberts: But of course a lot of people would argue that, ‘Well, growth is just an abstract statement about the macroeconomy. It doesn’t really affect everybody’s daily life; in fact, most people don’t get to participate in it. It only goes to the rich.’ And that encourages people to start thinking equality is more important. And that [inequality] has been much more of a focus in the political debate, the policy debate, over the last 5–10 years.

John Cochrane: There is an interesting issue of problems of government statistics rather than problems of daily life. But I think in fact the slowdown of growth is the problem of daily life. We’re really perceiving — people talk about — I don’t like to use the word ‘middle class’ because we’re not a class society, but people talk about the stagnation in middle class incomes. That’s a phenomenon of the slowdown of growth. And I think when people say, ‘I’m worried about inequality,’ what they mean is, ‘I’m worried that people aren’t getting ahead.’ And if someone else is getting ahead more or less doesn’t really matter. What really matters is, are the bulk of people getting ahead or not? The worry about inequality is a symptom, not a cause of problems.

Russ Roberts: I happen to agree with you, of course, but a lot of people don’t. A lot of people would say that’s not what it’s about; it’s really about, say, the ratio of CEO [Chief Executive Officer] salaries to, say, the average worker; they worry about even employment and the possibility of the future being much less glowing for the so-called average worker. Are you worried about that?

John Cochrane: I think we should worry about that. I think the think-out-of-the-box aspect of our grant policy is to listen hard to those problems but not jump to obvious and counterproductive “solutions.” Where does [inequality] come from as an economic phenomenon? You read through what most of economics has to say about it, and you [encounter] the common words ‘income went to.’ The problem is: Income is earned by.

Russ Roberts: Well said.

John Cochrane: There is no grand “somebody” distributing income. The rich didn’t get richer: new people came in and made a lot of money. What happened? The returns to skill went up, so that people living where we are [Stanford, California] and who know how to program computers and live where we are in Silicon Valley, are making a lot of money. And these are new and different people. And they start new companies, and companies have a global reach; they can make a lot of money.

The economy as a whole isn’t doing that well, but let’s think about supply and demand. When cars came in, and horses were out of fashion, people who knew how to shoe horses weren’t doing that well; and people who knew how to repair cars were making big salaries. Why wasn’t there big inequality? Well, because people who were shoeing horses learned how to fix cars. When there’s a big increase in the return to some skill, people should be getting the skill.

Why isn’t that happening? Well, America’s education system is quite broken and not letting a lot of people move into a lot of those places. America’s zoning system makes it very hard to move to the Silicon Valley. And take America’s immigration system — it makes it very hard to hire foreigners who know how to do stuff and come in. So the inequality that you see is a symptom of a lot of other economic policies. We have a more regulated, more cronyist — I want to channel a little Bernie Sanders and Elizabeth Warren, here. They have a point.

Even an economy where the rewards are more and more toward ‘You need to get the government regulators; there’s a monopoly; you need to get in,’ people are going to be making money out of those protected businesses. So that’s where a lot of inequality comes from. These are all symptoms of a problem. Leaving things screwed up and then taking your money and giving it to someone else makes matters worse. Let’s get back to the growth.

Russ Roberts: Let’s talk about the education system. I often say, ‘The biggest thing we need to do is fix the education system, give people a chance to join this economy.’ It’s pretty clear to me that not everyone can do STEM stuff. So, what do you think the bulk of American young people are going to be trained for in a future world that’s plausible, that our current education system is failing to train them for right now? That’s really a rhetorical question. I’m not expecting you to say, ‘Well, hydraulic engineers.’ But the question is: It’s not obvious that our standard answer is right, that it’s an educational problem. It may be something more structural that’s going on.

John Cochrane: Well, there are great barriers to moving out of poor communities, parts of very poor America. And education is a big problem. Let’s be economists. Everybody doesn’t have to move into STEM. If the 10% who have the talent can move into STEM fields, that drives down the returns to STEM and drives up the returns to the other things. If you let in some more immigrants who will start a business, they will hire more of those low-skilled workers. Low-skilled Americans know how to speak English. That’s a valuable talent. So, becoming a society where people can move around and use all sorts of different skills, then things equalize on their own. And, as good economists, we should know: it’s not up to us or some Federal bureaucracy to decide, ‘Aha, the future is in hydraulic engineering.’ Every time they do that they get it wrong. So, let’s get rid of the barriers and let people figure it out.

Russ Roberts: (10:09) Before we move on to some specific areas, I want to ask one last question about growth. A lot of economists, have argued recently that our problem with growth is a structural problem. It’s not a policy problem; it’s just a reality. It’s the new normal. It’s certainly the new normal in the data. But do you think it’s the new normal in the fact that something has changed fundamentally in the productivity of the U.S. economy?

John Cochrane: Long run growth comes from one thing, and one thing only: Productivity. New and better ways of doing things. New and better products, new and better companies. It doesn’t come from 90% of the things that we talk about—the Federal Reserve, stimulus programs, even anti-inequality programs. Over 10–20 years, it’s about productivity. You might have had a grandparent who dug coal with a pickaxe. How did you get so much richer?

Not by your union getting him higher wages and someone now digs coal with a pickaxe at 20 cents an hour, instead of 10 cents. No, it’s because one guy left and now people use a bulldozer. Right? Growth comes from productivity. Productivity comes from new companies, doing things new ways, and making life very uncomfortable for everybody else. Uber is the great example. Uber is a great productivity enhancement. It’s putting a lot of people to work who otherwise couldn’t go to work. And the taxi companies hate it. And most of economic regulation is designed to stop growth. It’s designed to protect the old ways of doing things. So, what we need for growth-oriented policies is exactly that kind of innovation, that kind of new company coming in an upending the status quo, that make everybody uncomfortable and run to their politician to say, ‘You’ve got to stop this.’

Russ Roberts: Yeah; I don’t always think about that. I have a tendency, I think, to look at what we would call in economics, rent-seeking: the attempts to preserve what you already have through regulation rather than excellence. That offends me morally. I love the idea that I can get a ride any time I need one and know that it’s coming in 3 minutes or 4 minutes or whatever it is; and not have to take the money out of my pocket. But it’s also a productivity thing: it’s also having a much wider range of impacts beyond that one market than isn’t obvious at first glance.

John Cochrane: I think that the best argument for it is not the moral one. It’s the practical one. This [kind of innovation] is what made us so much richer than our grandparents, and so much healthier, and what brought us all these great products.

Russ Roberts: And our grandparents would be thrilled to see how well off we are, even though their lives may have been challenged by the competitive process and creative destruction. I always emphasize that because I think that’s just so important: I understand if you are a cab driver, it [Uber] is hard for you. But do you want to live in a country where your children or grandchildren are going to live the same life that you did or maybe a little bit worse? Or do you want to give them a chance to evolve and change and grow and have a new set of opportunities?

John Cochrane: You asked why are we slowing down? And there is an economic discussion about this right now. And I’d say there’s three views of the world. One, the economy is functioning as well as it can. We just ran out of new ideas.

Productivity comes from new ideas, new ways of doing things, as much as new iPhones, as much as Southwest Airlines figures out how to turn a plane around in 20 minutes and it still takes United an hour and a half.

[So] it’s not just new products: it’s new ways of doing things, usually embodied in new companies. ‘We just ran out of ideas.’ Bob Gordon has written a very influential book basically on that. We’re in the Valley here, so when people stuff like that, they say, ‘You’ve got to be kidding, because we’ve got all this great stuff here; if we could only get the regulators to let us do it.’

The second view is that we have perpetual lack of demand. We have secular stagnation, and what we need is for the government to borrow a ton of money and build — well, the advocates of this want us to build like a high-speed train from [?] to Winnemucca. Actually, the ice wall of Westeros along the southern border is infrastructure and would have stimulus, but you don’t hear them — I don’t want it either.

[They say] what we need is just big public works programs, ‘Blow a lot of money because there’s lack of demand. Otherwise the economy is fine.’ I don’t go with that one, either. My view is that we have creeping regulation sanding the gears. What’s hard about this is every little market is screwed up. There isn’t one big ‘Aha,’ we just need a stimulus program and we’re all done. But if every little market is screwed up then the economy as a whole slows down.

Russ Roberts: (15:55) You argue that what we really face is a lack of respect for the rule of law. Tell me what rule of law means to you and why it’s so important.

John Cochrane: Here’s a good place to start trying to break out of the standard right/left partisan [debate] — it’s like a very old marriage where they are yelling at each other, ‘You’re a terrible cook.’ ‘Well, you don’t pick up your socks.’ They’re just getting no where.

Russ Roberts: I’ll kind of leave that lying there. That’s awesome. I’m going to refrain from adding anything to it.

John Cochrane: That’s the level of our economic discussion. Our job is to help our betters as sort of marriage counselors to break away from this discussion and get somewhere. So, in the context of regulation, I think we’re seeing regulation that is really hurting American business; it’s hurting innovation. But then the argument goes, ‘He says we need more regulation; she says we need less regulation,’ and we’re getting nowhere with that. What I’m seeing when I’m out [in the economy] is not so much the quantity of regulation but the nature of it. In most stuff that’s out there — you think of health care, you think of banking, you think of any actual business — it’s not like there’s a set of rules, and you just read the rules and you’re done. And they might be onerous but you know what they are.

So I’ll say a good thing about a government agency: I’m a pilot, as you mentioned. The FAA (Federal Aviation Authority) has a long rule book, and most of it’s really silly. But if you read the rule and obey the rule, you are done. You don’t have to ask for permission for something: you obey this silly rule, and that’s the end of that.

Russ Roberts: So, I know from talking to you that one of the rules, which I mentioned a bit earlier, is you can’t go above 18,000 feet. Is that correct?

John Cochrane: At 17,999 you are fine; 18,001, the FAA is going to see that on your transponder and you are in trouble. Now, most regulation that we have now, part of it’s complex; part of it’s the vagueness. There’s not just some rule, you know the rule, you obey the rule. The Fed’s stress test is an example. They just come in and they kind of make [the rules] up: you pass, you fail. There’s no way really to know. With the rule of law — if you were charged with a crime, you have the ability to see the evidence, and challenge the evidence. If the EPA (Environmental Protection Agency) says, ‘No, we’ve determined you’re no good,’ you don’t have that right. [And] where’s your right to appeal? Most of the regulatory agencies are prosecutor, judge, jury, and executioner all rolled into one.

The rule of law itself is fundamentally there to protect your political freedom. What banker dares speak out against the Dodd-Frank Act? What health insurer dares speak out against the ACA (Affordable Care Act) itself or the administration that uses it? When the regulator has the power to just shut down your business, people learn to shut up very quickly. That’s why this sort of thing keeps going. So let’s bring back the rule of law.

I think this is a way to get out of the more versus less: Is it simple and precise or vague and complex? Are the rules knowable or do they come after you ex post: ‘Oh, you were 10 feet away from an endangered seal. We’re going to throw you in jail for a while.’ They actually do stuff like that. Can you read the plain text of the rule or do you need to get some fixer with connections in the agency to get you through? Do you have the right of appeal? Is it isolated from the political process? Can they just delay endlessly, or is there a right to some answer? These are the rule-of-law protections. And I think the answer to a regulatory problem isn’t just the stale ‘more or less.’ It’s to bring back that kind of process.

Russ Roberts: (20:18) I think that’s a great insight. The challenge of making it a compelling argument for people to get behind is to convince them that something has changed, that there’s something new here. Many people collect measures of regulation. They look at, say, compliance cost; they look at the pages in the Federal Register. But those are blunt, blunt, blunt. That’s not a good measure. You are talking about something very nuanced and subtle. And one response to it would be, ‘Well, it’s always been that way. It’s always been a lousy, vague, opaque, non-rule-of-law system if you want to run a business. To convince me you’re going to have to show me it’s gotten worse.’ Can you do that? I’ll give you three minutes. [laughs]

John Cochrane: We’re like the drunk looking for his car keys where the light is, even though we know the problem: the keys got left over there in the dark. We go after things we can measure. The difficulty a company has in getting approval [complying with the] regulations — there isn’t a government statistic on that like there is for the unemployment rate or the CPI (Consumer Price Index). There’s a lot of anecdote, but anecdote doesn’t add to data. I think that’s a challenge for researchers: can we measure this sort of thing? A prominent left wing economist said to me, ‘John, you’re out to lunch. I’m out here in the Valley; I’m talking to all the executives. They’re not having any problems.’ The answer to which is, ‘Wait a minute. You’re talking to people who still are in business.’

Russ Roberts: A little selection problem there.

John Cochrane: It’s the ones who aren’t in business any more. The one who couldn’t get their approval. It’s the ones who languished in front of the FDA (Food and Drug Administration) for eight years and finally they ran out of money. Those are the guys you need to talk to.

Russ Roberts: And of course the other fact is, industries here — I don’t think it’s a coincidence; I think it’s actually a fact of life of political economy — the industries here are relatively left alone. Whereas, if you are in banking, if you are in health, if you are in certain sectors, it’s a very different environment. I think that where I’ll concede your point most dramatically — and you’ll tell me if I’m right or wrong, here — is Dodd-Frank finished?

John Cochrane: No.

Russ Roberts: Is the Affordable Care Act actually written ? It’s been the law of the land, both [Dodd-Frank and the ACA] have been the law for a while now. Usually you’d think you would literally at least know what’s in it even if you can’t understand it. The joke was, ‘We’ll pass it now and then we’ll later find out what’s in it.’ You can’t even do that yet.

John Cochrane: One of the difficulties of our regulatory scheme is that Congress passes 2000-page bills that then tell the agencies to write 20,000 pages of rules. And they aren’t even done making the rules. And then the rules are things like, you know, ‘You shall not have an abusive or manipulative sales plan.’ Who knows what that means. So, these things are still growing. But Congress is waking up, and they’ve figured out that they’ve made a mistake in writing these loose laws; and they are starting now to walk back. I think the return of rule of law in regulation is something that we may see. I’m not the first one to notice that this is a problem.

Russ Roberts: I always like to hope, I think naively and probably foolishly, that somehow people will be shamed into thinking it would be inappropriate to write these rules.

John Cochrane: As economists we’re probably stepping outside what we know. But as a legal matter, we’ve moved in a very different way. We used to have laws that were made by Congresses and enforced by judges. And most of what counts as law now is made by regulatory agencies and enforced by them, quite outside the legal system.

Russ Roberts: What is called the ‘Administrative State’. One of the things that fascinates me about it is how little the average person knows about it. I know almost nothing about it, and I’m a professional economist. In theory I should know about it. I know virtually nothing about it. We sort of assume that when a bill is passed that it’s implemented. But of course, as you point out, dozens, hundreds, thousands of rules get put into place — that whole process is a black box. To us. Not to the people, I suspect, who are being affected by it. I suspect they are working away.

John Cochrane: To your question, there are plenty of measures that say the American economy is losing its dynamism. I think one new bank has been chartered since the passage of the Dodd-Frank Act, and that was designed to help Amish people. No new health insurers; in fact, lots of health insurers are disappearing. Banking and health insurance are heading toward a very European model: 3 or 4 very regulated [companies.] They are not going to go bankrupt. The regulators can say, ‘We’re going to be mean,’ but there’s 3 or 4; nobody enters, nobody leaves; and you are going to have the same 3 or 4 businesses there 20 years from now than you do now.

The regulators, when they quit, they go to make a nice salary, back in the companies. The companies, they take their turn with the regulators; and, no innovation, nothing. So, you can measure things like what’s happening to the number of businesses. New business formation is way down. People don’t move much in the United States any more. So there are measures of that sort of thing.

Russ Roberts: Let’s look at some specifics. Let’s start with a hugely important area that doesn’t get a lot of attention these days, which is taxes. We have an incredibly complicated tax system which benefits mainly people who help people with their taxes.

John Cochrane: And help people who pass laws that give them special loopholes, yes.

Russ Roberts: And the people who qualify for the special loopholes. But, you know, in a way it’s funny. We say those things and they sound like clichés: ‘Oh, yeah, special loopholes.’ But there really are special loopholes, aren’t there? So, talk about what we might do differently in the area of taxes.

John Cochrane: In taxes, as in regulation, I think another theme that we should be screaming from the mountaintops is: Bring a reasonable simplicity to our public life. You know, it’s just ridiculous that we have 50,000 pages of regulations that nobody knows what they are. Simple, robust systems are going to work a lot better.

Russ Roberts: It’s rather extraordinary that you can give somebody’s [financial] life to 6 different tax preparers and they can’t agree on what the tax bill is. That’s stunningly bad for democracy, isn’t it? It’s horrifying.

John Cochrane: Well, what the peasants with the pitchforks are telling us is they’ve gotten wind of the incredible unfairness. When a system is this complicated, you know the guys with the connections are getting ahead. And for a long time we’ve put up with it; and now that economic growth has slowed I think you are seeing people not putting up with it.

Let’s talk about taxes. Because I think that it’s a great place to discuss, not just the economic question, which is actually quite easy, but the question: How do we get out of the tired discussion? You have to ask an economist who isn’t in public trying to get a job with a politician. But, ask him in private, give him a beer: ‘What should the tax system look like?’ Pretty much any economist will say, ‘We should have a tax on consumption — on people, on consumption — at a relatively, with low marginal rates and a very wide base.’ Pretty much every bipartisan commission takes you in that direction. And yet we can’t get there. Why not?

Because the discussion is this tired discussion about higher taxes versus lower taxes. Put out a tax plan and what happens? ‘Oh, well, a family of four with two dogs and a cat and lives in Fresno is going to be paying $256.20 more.’ It’s all about who pays more or less. But you took your economics class. The number one thing that matters is: What are the incentives? How does this distort economic activity? So, how do we get toward something like a consumption tax.

I want to eliminate the corporate tax. Completely. Why? Not because corporations shouldn’t pay. Corporations never pay [anyway]. Corporations, every cent that they pay comes from higher prices, lower wages, comes out of your pockets. And, if there’s a corporate tax then there’s an immense incentive to go to Washington and get deductions and loopholes and tax extenders and all the other crazy stuff that they do. The cronyism that infects our political system — the only way to get rid of the cronyism is: Get rid of the tax.

But we’re trying to do too many things. The problem with our tax code is: We’re trying to raise revenue for the government; we are trying to raise revenue, subsidize activities, transfer income, and decide the total size of the government — all four. And the key to marriage counseling is, when you are talking about 4 things at a time, you are never getting anywhere. So, I think the key is to break these apart. We should discuss the structure of the tax code. Now, every time they discuss the structure of the tax code, they talk about the rates: ‘We’ll have one rate at 16.2%, another rate at 22.5%’ — and then the arguments start. How about we discuss the structure of the tax code with the rates blank? Let Russ and me do the structure of the tax code; and we’ll let Bernie Sanders fill in the rates.

Russ Roberts: Good deal.

John Cochrane: Or we’ll discuss the rates separately.

Russ Roberts: We’re going to have so many friends, John. It’s going to be great.

John Cochrane: I meant that as a joke.

Russ Roberts: I know you did.

John Cochrane: I think you can come to agreement, Left and Right, on the structure of the tax code, if you are not simultaneously arguing about the progressivity of the tax code. And, the subsidy code. So, for example, we should get rid of the — let me take a sacred cow, the mortgage interest deduction. The mortgage interest deduction is equivalent to taxing middle class, hard-working people and sending checks to people in Palo Alto who just refinanced million dollar homes. It subsidizes high-income people who pay high tax rates, and therefore can take a big deduction. It subsidizes people who have big houses. And people borrow money for big houses.

If you said, ‘We’re going to do this on budget as a subsidy,’ the peasants with pitchforks would be out in the streets. And properly so. But how do you get rid of this? Well, let’s change the discussion. We’ll have the tax code and raise revenue; and we’ll have the subsidy code. We’ll sit down with Bernie and fill in the rates later. We’ll sit down with all the interests and say, ‘Fine. We’re not going to rule out the mortgage interest deduction. We’re just going to do it as a subsidy. On budget.’ You want to propose that we send checks to people who want to borrow a lot of money for their house? Fine. We’ll talk about that. It’s just, it’s going to be on budget; and it’s going to be a check. Non-profits — we should get rid of that — I hate to say this, in this Institution. I might get fired. The charitable interest deduction is similar — we should get rid of that. And of course if we get rid of the corporate tax there would be no such thing as non-profit versus profit, so this whole business would go away.

Russ Roberts: (32:36) You made an interesting point in a paper you wrote about how many athletes have foundations. Which seems like it’s a great PR (public relations) thing for them. You think they are doing all this good work. But there is this nepotistic part of it.

John Cochrane: If you have a lot of money, set up a charitable foundation because then you can use the charitable foundation to fly all your relatives in and out of town on private jets that come for the Board Meetings. And that’s how you can avoid the estate tax, because the Foundation lives on but all your kids can keep working for it at high salaries.

Russ Roberts: I didn’t think about that. It’s such a disturbing and cynical view, John. But I think you are on to something there. Carry on.

John Cochrane: And if you guys want to propose a bill where every American gets to say, ‘I want to give money to Russ Roberts, and I want the Federal government to match my contribution,’ and if I’m a rich person, they are going to give a higher match than a poor person, that’s fine. That’s exactly what the charitable deduction does. Fine.

Russ Roberts: It is bizarre.

John Cochrane: Suggest that bill. [Then there are all these] middle-aged men in Palo Alto driving Teslas. They are really cool cars. Okay? The only thing that bugs me is I look at everyone go by and I know that I spend $7500 on that car. But that’s a tax deduction. That’s fine. We don’t have to argue about that when we’re fixing the tax code. Subsidize green roofs and your solar cells and your electric cars and all that — fine. Just propose it, put it on budget, as a separate matter.

The way to clean up tax code— the tax code rates [deliver] money for the government. Separately we will redistribute income, largely by sending people checks. And that will be on budget; and we’ll talk about how much we send people checks. And the subsidy code — the United States tries to pretend that we spend a lot less money than we do.

The way we do it is we have mandates. We say, ‘You shall provide x, y, and z for your workers.’ That makes it look like we are not taxing and subsidizing. But we actually are. So, we are going to tax more and we are going to spend more. We’re going to recognize what we’re doing. But if we can separate that out then we can fix the tax code to raise revenue at minimum economic distortion. I believe enough in democracy that we can do a far better job of income distribution and of subsidizing activities if those things are torn out of the tax code and on budget, in the open.

Russ Roberts: I’m learning a lot more than I’d like about the differences between you and me and about myself —

John Cochrane: I’ve got to interrupt you. I’m not proposing. I’m trying to start a conversation. I have my answers on how much we should be subsidizing things. But I want to get somewhere. We’re stuck in a bad marriage. We have different answers to these things. How can we separately discuss them so we make progress in a democracy on these tough issues? And, how can we get to a compromise that is much less destructive for economic growth and fundamentally for that democracy?

Russ Roberts: My observation though is about our sociological differences. When you see a Tesla go by, you see $7500 coming out of our pockets. When I see it go by, in the license plate spot, before they get their license plate, it says ‘Zero Emissions’. And that offends me, because it takes a lot of carbon-based stuff to create the electricity to push that car around. And if everybody had a Tesla, it would be an enormously polluting car through its energy source. The injustice of that ‘Zero Emissions’ is what drives me crazy. And $7500 out of my own pocket — okay, I’m resentful of that, too.

John Cochrane: Around here, they do like to put ‘Zero Emissions’ on their license plates. And were I younger and a little braver, I would put a sign saying ‘Powered by Coal.’

Russ Roberts: (37:06) I’m sympathetic, of course, to your argument about taxes. And again, what irks us about these things may be different. You may be bothered by the incentives. What bothers me, among other things, is the thousands of hours that really smart people spend trying to evade and manipulate that code who could be doing something to make the world a better place rather than making sure that people’s money isn’t taken away by the government.

John Cochrane: And especially corporate taxes. Because they have the time and manpower to spend all their effort — all these inversions we’re hearing about, all the best minds are sitting about thinking about ‘How do I move my money around the world to lower taxes?’ As opposed to making better products for you and me.

John Cochrane: Back to energy for just a second. There’s a proposal that I’m actually hearing, coming from real environmentalists and real libertarians, which is: ‘Look, let’s trade. You guys can have a carbon tax, in return for we get rid of all the crony subsidies, all this business of who gets a Federal contract, all of the HOV (High Occupancy Vehicle) lanes, special tax deductions, and so on and so forth.’ The environmentalists are going that way because they realize that all the little stuff isn’t doing any good to reduce carbon. And the libertarians like it because, yeah, they might not want the carbon tax in the first place but at least there’s a way to solve this problem in a way that’s much more economically efficient, much more efficient with people’s time and effort, much less distorting of which technology actually gets used and much less distorting of our political system.

Russ Roberts: So, listeners know that I’m skeptical about the ability of econometricians to measure things with any precision and to separate out complicated household problems. But most economists could come to some measure of the total gains that would come from the kind of reforms that you are talking about; and they’d be very large. There wouldn’t be a precise estimate, but when you add up the costs and time, the incentive effects, the wasted effort, the lost productivity because things aren’t being done that could be productive, it’s a big number. And that raises the question of: ‘If you’re so smart, why don’t we have better policy?’ Why is reforming this system so difficult? Is a grand bargain ever possible in our current political environment, on any of these issues? And, are we just wasting our time here? Not that it isn’t fun. I’m having a good time, myself.

John Cochrane: Well, I think we need to be optimistic. Because the choice is grand bargain or the end of Western civilization — take your pick.

Russ Roberts: So it’s not the road to serfdom — it’s even worse? What do you mean, ‘the end of civilization’?

John Cochrane: We have had grand bargains before. The 1986 tax cuts, the Carter era deregulations. On taxes, the current problem is when you say, ‘Let’s have a tax reform’ and ‘We’re going to do stuff like get rid of the health care deduction, the mortgage interest deduction, the energy tax credit, and so forth,’ well, the energy people, the housing builders, they are all in your office saying, ‘Oh, no, that’s the end of the world if we get rid of my thing.’ The problem is, each one says, ‘Well, they’ve all got their thing, so I’m going to make darn sure I’ve got mine.’ And the job of a great politician or a great party or those who form the coalitions is to get us all to, ‘Okay. I’m giving up mine, so I’m going to make damn sure you give up yours, too.’

Not just, ‘I give up mine; I understand we’re all giving up, so I’ll suffer.’ You need to form a coalition where everyone is part of the coalition saying, ‘Okay, if I’m giving up the mortgage interest deduction, you’re giving up the health care tax deduction; you’re giving up the energy deductions; you’re getting rid of all the other stuff that’s going on.’ I’m an economist, not a politician. That’s their job; that’s what we should be voting them in for. And good ones, that’s what they do.

Russ Roberts: But, one of our jobs is to point out that the challenge of creating those coalitions comes from the fact that if I propose a policy where there are a lot of losers or there’s a small number of really big losers, it’s going to be much harder. And I guess one way to think about it, in a time of crisis, you might, maybe be able to mobilize people — because it’s the end of Western civilization hanging over them, that they might make a sacrifice for the good of the country. Otherwise, it’s, ‘What’s the incentive for me?’ And ‘what’s in it for me’ is really, I think, the biggest barrier to these kinds of changes.

John Cochrane: Well, I think we should stop playing amateur politician, or political scientist. I think where you and I as economists can help is to outline all the areas where our political friends are stuck in a stale argument. Because in many cases they are stuck — a politician has to spend 16 hours a day raising money. So, if they’re not that great on the second order derivatives or on supply effects, or on just the basics — that you don’t transfer income by distorting prices: that’s one of the most basic things in economics, that there’s always a supply response. So, our job is to help — we’re marriage counselors. Let’s find those out-of-the-box ways of addressing each of these problems — we’ve talked about some — that will help them to listen to each other and form those grand bargains.

Russ Roberts: (43:00) I love the phrase ‘peasants with the pitchforks.’ And it reminds me of one of my favorite movies, The Court Jester, with Danny Kaye. It’s a neglected classic. And for those of you listening at home who have seen it will appreciate — I’m just going to say, ‘the chalice from the palace has the brew that is true.’

But the peasants with the pitchforks have the poison — and you won’t get it if you haven’t seen it, but check it out; you’ll find it. It’s one of the greatest moments in cinema.

I have to note that the peasants with the pitchforks right now advocate for things that move us away from the directions mainly that you and I would like. On one side of that divide we have the peasants with the pitchforks who want to tear down Wall Street, and who are supporting Bernie Sanders. On the other side of the divide we have the peasants with the pitchforks who want to put up a wall between the United States and Mexico. That’s a big challenge—the taste in the general public for the kind of reforms that you and I want to see doesn’t seem to be there.

John Cochrane: When I use the phrase ‘peasants with pitchforks,’ I’m echoing how much disdain our elites have for democracy.

Russ Roberts: So it’s not your disdain? Okay, sorry.

John Cochrane: Not mine at all. I think that people have a lot of wisdom. But the average person is busy; and it’s not the average person’s job to [fix] our economy. Our society is a cause-and-effect machine with very delicate relationships between where you push the lever and what actually happens. That’s what’s beautiful, that’s what’s fun about understanding economics.

That we’ve subsidized x doesn’t mean that we all get richer. It costs y, and you’ll all get poorer. And seeing those things is hard. The average person senses that the system is rigged; that growth is too slow; that there’s sand in the gears. But it’s the job of a leader to unite those feelings and to give them expression. And I don’t blame the peasants with pitchforks at the moment. I blame very much the themes that leaders have chosen in order to exploit their geniune feelings that something is very wrong.

Russ Roberts: Totally agree. Let’s move on to an area you’ve written a lot about that I think is a huge challenge. It is part of this, I think, populist concern, which is the financial system and the way the government treats it. You’ve mentioned Dodd-Frank. Dodd-Frank is the second-most important legislation of the last 8 years. It purported to solve many of the problems that caused the financial crisis. You don’t agree. What’s wrong with it, and what should replace it?

John Cochrane: You have to understand what people are thinking. They are not dumb people. They are trying to do their best. And both of them are classic cases of the Little Old Lady Who Swallowed a Fly. And I don’t know if you know the children’s story— she swallows a fly, and then she swallows a spider to catch the fly, and then she swallows a cat —

Russ Roberts: There was a cow, eventually, I think.

John Cochrane: [Spoiler Alert!] It ends with a horse — she died, of course. But each step makes sense. And that’s exactly what happened here. So, the Dodd-Frank Act was nothing new. In the 1930s we had a financial crisis and the government went to this idea that what we’re going to do is we’re going to stop the financial crisis by guaranteeing debts so that people don’t run to get their money out. Then there’s a problem: if you guarantee the bank’s debts, that’s like saying, ‘Hey, I’m going to guarantee your debts; go to Las Vegas and whatever you ring up’ — so there’s a problem there. So now we have to have regulations. ‘No, you can only go to the craps table and — ‘

Russ Roberts: can’t spend more than this much on a bet —

John Cochrane: and then of course if we do that, then you’re going to find some way around, and then you’re going to lose money again; and I’m going to have to guarantee bigger debts, and more regulation. And you can see the spiral. Every time something blow apart, what do you do? We have to guarantee the debts, to bail out to stop the crisis.

And then, oh, gosh, now we have another layer of incentives for you to behave badly, so we add another level of regulation. It gets bigger. And that’s just what Dodd-Frank did. The ACA was the same thing: we had the same spiral of problems with health insurance, which we’ll probably treat later, given the time. So that’s what went wrong; and now you have this monstrous thing that, it is ‘swallowed a horse’. And it’s not going to die. It’s just going to turn into, the French phone company in 1965 — just this sclerotic thing.

And although you’re saying how wonderful Silicon Valley is: you know, Google has a lot of contacts with Washington now; and the FTC (Federal Trade Commission) just regulated the Internet like a utility. So, we’ll so how long this stays that way.

You’ve got to go back to the beginning. Let’s find simplicity in our public life. The system of: You get to borrow a lot of money and we’ll bail things out when you go wrong is — we can’t do that any more. And fortunately technology means that we can go back and re-examine that basic premise, that banks can get your money by always letting you come and take it out any time you want. That’s the basic problem.

Because that causes the run. So, if we set up a banking system where, you go to the bank and it looks like it does now except it’s like a money market fund; the price might go down. If you own stocks, you can’t go get your money out of the stock market any time you want. You can’t force a company to go bankrupt. So if banks were set up like that, where they issued something that looked like stock — rather than issuing something where you can come get your stuff any time you want then there would be no financial crises. We wouldn’t need any regulation. The whole system would be much simpler. And that was a decision we decided not to do in the 1930s, because they don’t think it would have worked in the 1930s. Now it can work beautifully. You can just swipe a card, sell some bank stock; have cash in 20 milliseconds.

Russ Roberts: You’re saying I will be able to get my money whenever I want. Because I do want that. Right? You are just saying that what will underlie that will be different.

John Cochrane: To have instant liquidity, you don’t need a promise that the value of your claim is always the same. So, if you have a stock, the stock can go up and down. You can sell the stock instantly. But you can’t go to the company and say, ‘I gave you $100; the stock price is $90; I want my $100 back; and if you don’t give me that $100 back you are bankrupt.’ You go to a bank, and you can do that. That’s why banks fail.

But companies that issue a lot of equity can’t have runs. There can’t be financial crises; and so we don’t need the whole array of regulators telling them what to do. Let me just add: It’s really hilarious how much effort we spend on regulating bank risks. What are banks’ assets? Banks’ assets are loans. Banks assets are bonds. They’re fixed income. They’re about the safest thing around. The cash flow of any venture capital startup, the cash flow of Google, the cash flow of Facebook is much, much riskier than any of the assets of a bank. Why are we spending all of this effort regulating the assets of the safest companies in the world? ‘Oh, because they are leveraged like 90-to-1.’

Russ Roberts: Meaning, they are using borrowed money rather than equity.

John Cochrane: They are using borrowed money. And the taxpayer is standing behind the borrowed money. If they issued equity, these would be just safe, boring companies needing practically no regulation.

Russ Roberts: (52:02) Which, of course, is one of the political problems: If you are not doing anything for somebody you can’t sell them anything. So, politicians aren’t going to be able to extract any resources from them. But let’s put that political economy to the side. I just want to understand the idea —

John Cochrane: I want to push back on your premise that democracy is doomed because it will always serve interests.

Russ Roberts: I didn’t quite say that. That’s a slightly exaggerated version of what I said.

John Cochrane: You always have to make some claim about how this is in the public good. There is a media. The mechanisms of democracy — us having opinions about stuff — that is our one hope of constraining the function of government in just appearing to regulate in order to transfer resources.

Russ Roberts: Yeah, but I would say that the growing size of the financial sector makes it hard to be optimistic about the way that that’s working right now, at least.

John Cochrane: Lots of sectors are big without hugely regulated. It’s the growing regulation of the financial sector; and it’s getting more and more entwined. People I know at the Fed are saying, ‘Hey, John, it’s good to see you. By the way, do you know that I just got this call from Goldman and they want to give me, you know, x million dollars to come help them on the things that I was regulating them on last week.’ Gee. That could get worse and worse if it doesn’t get better.

Russ Roberts: Yeah. I’m a little bit worried about that. But I want to ask you about this particular proposal, which is: I understand and agree that debt (leverage) is the reason that there are bank runs. But financial institutions in general are intermediaries between people who want to borrow money and people who want to lend money. Not people who want to play the stock market. So how are you going to get that square peg into a round hole?

John Cochrane: So, there’s a great Chicago Booth theorem, the Modigliani-Miller Theorem. Which goes back to Casey Stengel, I think it was, who said, ‘Cut the pizza, cut in 12 slices. I’m not that hungry tonight.’ Bank assets turn into bank liabilities. And the total amount of risk that is held by the private sector is the same no matter how much you slice up that risk between debt and equity.

So if you slice the risk up into lots more equity and lots less debt, that equity becomes much safer than current bank equity. Let me make this real. What happens? If you want something really safe, it’s going to look exactly like it looks today: You put your money in the bank and just what’s happening? The banks are holding a lot of Treasury Bills and reserves at the Fed. Your deposits are going to go into Treasuries and reserves at the Fed, which back them 100% —

Russ Roberts: And I’m going to get a very low return on my money for doing that.

John Cochrane: You’re going to get a very low return. You want a little more return, you’re going to have to put a little more, you’re going to have to bear a little more risk. But the total amount of risk held by the private sector is exactly the same if you just slice it up a little bit differently. In fact, one way to do it is, suppose the banks are 100% equity financed. That equity is very low volatility. It’s very safe equity. It’s an equity claim on bonds.

Russ Roberts: On people paying back their mortgages, say.

John Cochrane: On people paying back their mortgages. Which in a big pool of mortgages is very safe.

Russ Roberts: Most of the time.

John Cochrane: No, no, no, no. The subprime stuff paid off. A long, lonely pool of mortgages is a really safe asset. That equity could be held downstream in a mutual fund that parcels it up into equity and debt. And that holding company, you could resolve in a morning, because its assets are publicly traded equity; its liabilities are debt. Even if that’s highly leveraged, we don’t have to have the leverage in the bank. The leverage can be out of the bank. And you can blow that up in an afternoon. The problem when you blow up banks — and Ben Bernanke wrote the classic paper on this — the problem is when you blow up a bank, you blow up all that knowledge of how to make loans. That is what you don’t want to do.

Russ Roberts: (56:19) What you just described is very clever and very complex, to the average person. Right? What kind of steps could we take in actual policy to reduce the amount of debt that banks use and get us closer to that world in a way that might be feasible.

John Cochrane: I’m an optimist. That’s actually what’s happening. Now [the regulators] are going to capital ratios of 2, 5, 10; they’re talking about 20 being fine. So we are moving to higher and higher levels of capital. People are understanding the Modigliani-Miller Theorem: that higher levels of capital are not a drag at all on the bank. Historically they operated with 40% levels of capital. So we’re just moving slowly to more and more capital.

Russ Roberts: We’re almost out of time. I wanted to give you a chance to talk about what you think government should spend more money on, or do more of, rather than less of.

John Cochrane: There are lots of things. So, I think that government should recognize what it is actually spending rather than saying, ‘I’m going to force you to provide health insurance for your workers,’ I think it would be far better to recognize that as a taxing and spending. Social programs, we didn’t talk about how do we get out of the ‘Oh, we have to spend more — you don’t care’; ‘Oh, we have to spend less — you’re blowing up the future of your grandchildren.’ We’ve got to get out of that.

I think the problem with the social programs are their disincentives more than the amount of money we’re spending on them. Right now the highest-taxed Americans are poor people. And the reason they’re the highest-taxed is because if they earn $1.00 of income, they lost $1.10 of their benefits. They are facing horrendous effective marginal tax rates. Now, the only way to get around that problem is to be willing to spend more money to remove those marginal disincentives. But that helps people get out of the traps of social programs.

There are schizophrenics on the streets in Palo Alto. We should be spending money to help them. I think one of the answers for the social programs is more generosity but limited time, rather than limited money. I’m very unhappy with the way that America is turning into a class society, and your class is defined by your income. Your current income. We have low-income people, middle-income people, and high-income people. Well, you talk about this as if it’s forever rather than the transitory state where you are now. In Palo Alto you can get a big reduction on your parking sticker if you are a low-income person. What are we doing here?

Russ Roberts: What’s wrong with that?

John Cochrane: What’s wrong with it? It’s one more disincentive to not stop being low income. And it creates people who are in classes, like we are an old, aristocratic society.

Russ Roberts: I thought you were going to say that someone who has a bad year gets cheap parking. And then the next year, they are going to make a lot more money. They are a student this year, or something like that. Isn’t that a part of the problem if you are judging people by their current income?

John Cochrane: Yeah, that’s also part of it. It’s part of the insane complexity of the American system. If we really want to help poor people out, is signing up for a cheap parking pass in your city and then 10,000 special things the way to do it? That’s silly. No; I think there are plenty of good things that the government should do. And we should accept that fact.

[After this interview was over, John wrote at his blog, The Grumpy Economist, that he wish he had answered this last question about what government should do more of, differently. Read his answer here.]

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I host the weekly podcast, EconTalk and I'm the co-creator of the Keynes-Hayek rap videos. My latest book is How Adam Smith Can Change Your Life.

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