bhide - a call for judgment; sensible finance for a dynamic economy (2010)

A Call for Judgment
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AMAR BHIDÉ
A Call for Judgment
Sensible Finance for
a Dynamic Economy
1
2010
3
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Copyright © 2010 by Oxford University Press, Inc.
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Library of Congress Cataloging-in-Publication Data

Bhidé, Amar, 1955–
A call for judgment : sensible fi nance for a dynamic economy / Amar Bhidé.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-19-975607-0
1. Finance—United States. 2. Capitalism—United States.
3. United States—Economic policy.
I. Title.
HG181.B42 2010
332.0973—dc22 2010011238
9 8 7 6 5 4 3 2 1
Printed in the United States of America
on acid-free paper
For Lila,
Question, but deeply.
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CONTENTS
Preface ix
Introduction 1
I Ordering the Innovation Game: Beyond Decentralization
and Prices
1 The Decentralization of Judgment 29
2 The Halfway House: Coordination through Organizational Authority 46
3 Dialogue and Relationships 55
4 Refl ections in the Financial Mirror 64
II Why It Became So
5 All-Knowing Beings 83
6 Judgment-Free Finance 104
7 Storming the Derivative Front 132
8 Liquid Markets, Defi cient Governance 155

9 Financiers Unfettered 177
10 The Long Slog to Stable Banking 192
viii Contents
11 Not There Yet 215
12 Finally on Track 230
13 Derailed by Deregulation 250
14 Restoring Real Finance 270
Acknowledgments 299
Notes 301
References 323
Index 335
ix
PREFACE
This book refl ects a long-standing skepticism about modern fi nance born
out of two sides of my professional experiences. For more than thirty
years I have studied innovation and entrepreneurs in the real economy,
and I have had some involvement in starting new ventures. I have also
written papers in fi nance (my doctoral dissertation was on hostile take-
overs), consulted for fi nancial institutions, served on the staff of the
commission investigating the crash of 1987, worked for an investment
bank, managed a hedge fund, and traded on my own account.
The world of innovation and entrepreneurship has been uplifting.
The optimism of the entrepreneurs I have studied has rubbed off. Inno-
vation has generated unimaginable advances in our standard of living;
given the right incentives and rules, I believe it can take us a long way
toward solving problems ranging from the overconsumption of fossil
fuels to a health care system that gobbles up vast resources without pro-
viding commensurate improvements in our well-being.
The world of fi nance, in contrast, has been a downer (although
not as personally unrewarding as my entrepreneurial ventures, which

were complete failures). Perhaps because my worldview was shaped by
observations of real-world innovation, I questioned the common belief
that developments in modern fi nancial theory and practice were good
ix
x Preface
for society. Rather, I believed there was something pathological about
a fi nancial system completely at odds with the dynamism of the real
world. The real world is entrepreneurial and interconnected. Finance is
monolithic, almost Soviet-like in its conformity and far removed from
its users. Forward-looking innovators expect and envision change.
Finance relies on mechanistic, backward-looking models that assume an
unchanging world.
In the early 1990s, I wrote several articles arguing that the much-
vaunted breadth and liquidity of U.S. equity markets had serious
hidden costs, and took issue with the passive, judgment-free style of
investing. In March 2002, I emailed Matthew Bishop who was writing a
survey on the future of capitalism for the Economist that capitalism was
in great shape—except in the fi nancial sector. “The fi nancial system,”
I wrote, “faces a much sharper change in the trajectory it’s been on since
the early 1980s—much more so than the other elements of the modern
capitalist system that I think are here to stay. Of course if the fi nancial
sub-system starts unraveling, the other elements may also be affected.”
But what now? In 2007, about a year before the Lehman bank-
ruptcy created a global panic, I offered
1
what then seemed like far-
fetched proposals for fi nancial reforms, on which I have elaborated in
the concluding chapter of this book. Similar proposals are now being
advanced by more distinguished advocates, although they remain far
from the establishment view and the Dodd-Frank fi nancial reform bill

of 2010 that has just been signed into law by President Obama.
The case I make here is based on history, logic, and circumstantial
evidence. I cannot provide incontrovertible proof. Nor do I claim to offer
a totally objective, unbiased account (if such a thing is possible). My
hope is that after taking into account the perspective it refl ects, readers
will fi nd the argument persuasive.
Cambridge, Massachusetts
A Call for Judgment
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1
The economic crisis that began when the housing bubble peaked in
2006, that spread through virtually the entire fi nancial sector, and that,
in less than two years, brought the world’s economy to a near standstill,
has engendered two unwarranted interpretations: one too broad and the
other too narrow.
The excessively expansive view sees the fi nancial crisis as the conse-
quence of basic fl aws in capitalism as a whole. Few people, businesses,
industries, or countries have been sheltered from the crisis, and the wide
spread of its woes has rejuvenated anticapitalist critiques. Denunciations
of globalization, supranational corporations, the unfettered pursuit of
self-interest, the eroding power of unions, and the unjust accumulation of
wealth that rang hollow in good times now resonate. And the agenda of
many critics extends far beyond banking and fi nance. It includes higher
and more steeply progressive taxes, rollbacks of Reagan-era deregula-
tion, managed instead of free trade, the assertion of state control over
large corporations (starting with General Motors, now nationalized in
all but name), and stronger trade unions.
And why not, if you believe that all of capitalism is broken—or if
you didn’t like it in the fi rst place? Opportunities to revamp the existing
order don’t come by often. The time for a new New Deal may be now.

Introduction
2 Introduction
As Rahm Emanuel, President Obama’s chief of staff, said in November
2008, “You never want to waste a good crisis.” In fi elds as diverse as
energy, health, education, tax policy, and regulatory reforms, the crisis
provided an opportunity to “do things that you could not do before.”
1
The too narrow view focuses on fi nance and is usually offered by
those who have been involved as researchers, regulators, and, practitio-
ners. This inside view sees little wrong with the structure and evolution
of fi nancial institutions, markets, and practices—except to the degree
that the regulatory apparatus has fallen behind and some incentives are
misaligned. A smorgasbord of technical fi xes, accessible mainly to those
in the know, follows from this diagnosis. It includes the trading of instru-
ments such as credit default swaps (CDSs) on an exchange; improved
transparency through more stringent disclosure requirements; coun-
tercyclical capital requirements; changes in the models used by rating
agencies and how those agencies get paid; and teaching MBA students
about developments in behavioral fi nance.
Insiders reject radical measures that some outsiders have proposed,
such as prohibiting CDSs. Only troglodytes, they claim, fail to see the
huge value that modern fi nancial technologies would provide if only
they were a little better regulated. Some go further, arguing for an even
wider range of risk-management products so that we can hedge away
all serious risks.
This book challenges both views. It rejects the proposition that capi-
talism as a whole has failed and requires comprehensive reform, and it
rejects the view that the fi nancial system just needs technical tweaks.
Commerce and markets are ancient but modern, and what Marx
called “technologically progressive” capitalism started only with the

First Industrial Revolution, around the time of the American War of
Independence. In short order, capitalism helped unleash extraordinary
economic growth. Before the Industrial Revolution, wealth was largely
taken, that is, transferred from somewhere else, not created. Individuals
and nations prospered at the expense of others, and until the eighteenth
century, world GDP growth per capita was virtually zero. As capitalism
gathered traction in the nineteenth century, however, per capita incomes
more than doubled, and then, in the twentieth century, increased more
than eightfold. Growth was especially robust in the industrial nations
of the West.
2
Its capacity to deliver the goods allowed capitalism to prevail over
socialism and communism. And although it didn’t abolish misery, it
produced considerably less of it than its rival systems.
Introduction 3
But the dynamism of modern capitalism may not survive assaults
from its reenergized critics if the fi nancial sector continues to do busi-
ness more or less as usual. Finance has acquired features that are sharply
at odds with a system built to support a dynamic, capitalist economy.
And this is not a recent problem. Finance has been on the wrong trajec-
tory for more than a half a century: Its defects derive from academic
theories and regulatory structures whose origins date back to the 1930s.
Because my diagnosis differs from the two views I have outlined, my
prescriptions are different too. They urge vigilance against opportunistic
assaults on the vital elements of capitalism—a system that has delivered
unprecedented and widespread prosperity. And they go beyond tinker-
ing with the fi nancial system to urge bold changes in the rules.
The centerpiece of my proposals entails tough, straightforward
limits on the activities of commercial banks and other entities, such as
money market funds, which now total more than $8 trillion in depos-

its that are for all practical purposes guaranteed by taxpayers. I see no
reason to ban CDSs or impose further restrictions on hedge funds. Nor
do my proposals require commercial banks to stop taking risks. They
would merely stop banks from abusing protections provided to them by
taxpayers to enable the pathologies of modern fi nance that have almost
wrecked capitalism. Although the scope of the rules I propose is narrow,
they would profoundly change the nature of the fi nancial game.
Crucial Features of Modern Capitalism
Critics attribute many unsavory features to capitalism: Cold-blooded,
profi t-maximizing calculation rules. Personal relationships don’t mat-
ter: It’s all a trade in which price is everything and there is a price for
everything. The fewer the rules the better—they only get in the way
of profi t maximization. And a few winners of this ruthless free-for-all
capture most of the spoils. Even mainstream economic theories, which
don’t intend to criticize capitalism, incorporate some of these disparag-
ing views. In the typical college economic text, the idealized economy
features nerveless automatons that maximize profi ts (or utility) by buy-
ing and selling in anonymous markets.
These are mischaracterizations—far removed from the realities of
a well-functioning capitalist system—but understandable ones. The
nature of capitalism is diffi cult to grasp. One reason is its relatively
short, two-and-a-half-century history. Adam Smith’s Wealth of Nations,
4 Introduction
now regarded as a capitalist bible, was published before capitalism
came into its own. Another is its dynamic, evolving character. Capital-
ism in the twentieth century wasn’t what it was in the nineteenth cen-
tury; and, by virtually all measures, the change was for the better. So
it’s not surprising that misconceptions abound and that any sketch of
capitalism’s essence—including the one that follows—will have subjec-
tive elements.

My list of key elements of a contemporary, well-functioning system
of capitalism draws heavily on, and extends, Friedrich Hayek’s pioneer-
ing characterization.
Let’s start with some well-known basics: The continued prosper-
ity of modern societies, it is now widely recognized, requires constant
innovation—the development and use of new products and processes.
How capital is mobilized to expand the output of tried and tested tech-
nologies, or how the supply of existing goods is matched with demand
(“static effi ciency”), is an important but secondary factor.
Extensive decentralization, which allows many individuals an oppor-
tunity to undertake initiatives of their choosing, gives “Hayekian”
economies an outstanding capacity to innovate because they harness
the energy, talent, and know-how of many individuals that would be
wasted if people were told what to do. The democratization of innova-
tion—the development of new goods by the many for the many—is one
of the great strengths of the modern economy. Steve Jobs may orches-
trate the development of iPods and iPhones, but the success of these
products requires the contribution of thousands of engineers, design-
ers, marketers, and even copyright lawyers—employed by Apple
and its wide network of suppliers and providers of applications and
add-ons—as well as the venturesomeness of millions of consumers of
Apple’s products.
In a dynamic economy, it isn’t just the so-called knowledge work-
ers who innovate. In industry after industry, assembly-line and piece-
workers are also innovators. As Japanese automobile companies have
shown through the success of quality circle programs, top managers and
time-and-motion experts don’t always know best.
Decentralization of initiative isn’t simply a matter of dispersing
robotic calculations—replacing a giant mainframe at headquarters with
smaller personal computers in local offi ces so they can calculate utility-

maximizing levels of output and consumption. Rather, it involves giv-
ing many individuals the autonomy to make subjective judgments in which
emotions and feelings inevitably play a role (see box).
Introduction 5
Subjective Judgments
Whether and how to try something new cannot be simply a matter of
objective calculation. No one can predict whether a new initiative will succeed,
or even calculate the right probability of various outcomes. How much
happiness will follow success also is unknowable; sometimes the realization
of long-standing dreams can lead to letdowns. Unfathomable emotions
and subconscious drives, not just the pursuit of wealth (or the possibility
of pleasurable consumption that wealth provides), play a crucial role in
determining whether someone makes a “leap in the dark.”
3
The importance of primal passions was well recognized by economists of
a prior era. Joseph Schumpeter’s Theory of Economic Development credited
innovation to entrepreneurs with the “dream and will to found a private
kingdom” and the “will to conquer.” In his Principles of Economics, published
in 1890, Alfred Marshall wrote that just as a racehorse or athlete “delights”
in “strain[ing] every nerve” to get ahead of competitors, a “manufacturer or
trader is often stimulated much more by the hope of victory over his rivals
than by the desire to add something to his fortune.”*
Nor do individuals rely on mechanistic calculations alone in fi guring out
how to pursue their objectives. In undertaking something new, we cannot
reliably extrapolate from the past—even with the fanciest of econometric
tools. Historical patterns and models serve as valuable starting points, but
they must be adapted to novel present circumstances. For this sort of
assessment of prospects, individuals draw heavily on their imagination and
what we call hunches, gut feel, or intuition. And because of differences in
innate temperaments, upbringing, or life experiences, different individuals make

different choices. Reasonable people, in other words, can disagree.
Economies characterized by widespread decentralized innovation force
everyone, even those who are happy with the status quo, to make subjective
judgments. In a static society, or one tightly controlled by a central authority,
bakers can use the same kinds of ovens to bake the same kinds of loaves day
after day, secure in the knowledge that nothing will upset their bread pile. In
a dynamic economy, bakers must respond to the introduction of high-end
croissants or cheap, mass-produced sliced bread by competitors and to their
clientele’s craving for something new. Here, too, the past provides limited
guidance—bakers must somehow guess what to bake next.
*Marshall urged his fellow economists to study such motives carefully, because in some
cases they could “alter perceptibly the general character of their reasonings” (cited by
Robb 2009). As it happens, the force of the will to win has been taken more seriously by
novelists than in the economic literature.
6 Introduction
Decentralized responsibility goes hand in hand with the decentral-
ization of judgment. Well-functioning capitalism requires individuals to bear
at least some of the consequences, good and bad, of their choices (see box).
Responsibility, for Better and for Worse
Even those who play the game mainly for the rush they get from competition
are rarely indifferent to the material rewards. As Frank Knight, often considered
to be the founder of the Chicago school of economics,
4
wrote, the “motivation
of competitive sport” and the “pursuit of the gratifi cation of consumption” go
hand in hand. Economic activity is a game in which “the most vital substantive
goods [and] comfort” are “stakes, inseparably combined with victory and defeat
and their bauble-symbols.” A game that offered only bauble-symbols might turn
off some outstanding players who value real prize money, thus eroding even
some of the intrinsic thrill of top-fl ight competition.

Conversely, requiring individuals to bear some of the downside helps discourage
them from pursuing whimsical or ill-considered initiatives. Having skin in the game
concentrates the mind. It also discourages sticking with ventures that happen to
turn out badly for reasons that cannot be foreseen in a world of autonomous
choice. Entrepreneurs may diligently investigate their markets and competitors,
but they cannot force customers to switch to their offering, though it may be
objectively superior, or always avoid being trumped by another entrant who
appears out of nowhere.
That harsh consequence of unlucky ventures may seem unfair, just as it
may seem unfair to provide large rewards to individuals who get lucky, but it
does no one any good to keep throwing good money after bad. In a world
with unpredictable outcomes, decentralized responsibility works pretty well in
balancing “Nothing ventured, nothing gained’ and “Fortune favors the brave”
with “Look before you leap” and “Don’t buy a pig in a poke.” And in judging the
fairness of capitalism’s rewards, we should remember that modern societies
moderate the effects of good and bad luck through such mechanisms as
progressive taxes, limited liability, liberal bankruptcy codes, and unemployment
benefi ts, while keeping most of the benefi ts of individual responsibility, although
the balance isn’t easy to strike.
The advantages of decentralized initiative tied to individual responsibil-
ity isn’t news to those predisposed to believe in capitalism. The territory
has been well trodden by the followers of Hayek. But now we examine
features that may give more readers pause.
P
rices, especially those set in an anonymous market, play a role
in modern capitalism that, while important, is limited. For some
Introduction 7
economists, the price system is the sine qua non—the very essence—of
capitalism. They dream of complete markets that match supply and
demand for all goods, services, and contingencies, as a Promised Land

to be reached through diligent pursuit of capitalist ideals.
Well-functioning price mechanisms are usually an excellent way of
allocating resources—labor, capital, real estate, and consumers’ purchas-
ing power—across the myriad activities that individuals and businesses
undertake in a decentralized economy. In Hayek’s terms, they aggregate
information that individuals generate. Interfering with prices is usually
a bad thing, but when a society tries to promote certain behavior, work-
ing through prices is usually best—raising prices of fossil fuels through
a carbon tax is a more sensible way to stimulate the development of
renewable energy than subsidizing ethanol.
But prices aren’t a be-all and end-all. Competition is rarely just about
price, and most decisions—about buying houses, securing employ-
ment, seeking medical treatment, or going to the movies—involve con-
siderations far beyond how much money will change hands. Prices do
facilitate decentralized innovation by helping coordinate independent
initiatives, but they are not the only mechanism that does so.
Dialogue—between two individuals or among large groups, and in per-
son, over the phone, or via the Internet—plays at least as important a role
in coordinating actions and aggregating information. Extensive dialogue
with suppliers is particularly crucial for innovators who integrate cut-
ting-edge technologies and components from many suppliers. Smart-
phones can’t be designed by examining the prices listed in vendors’
catalogs.
Anonymous or arm’s-length markets play an even less important
role in the modern world than do prices. Markets in metals and in
produce (which are arm’s-length and practically anonymous) have
existed since antiquity, but such markets’ share of commercial activity
has decreased since the advent of modern capitalism. In contrast to tra-
ditional commodities—such as fi sh, vegetables, gold and silver—few
modern goods are traded in an anonymous market. A signifi cant pro-

portion of transactions now take place within fi rms (or “hierarchies,”
to use the term favored by some institutional economists). The rest
(unfortunately, in my view) are labeled market transactions, but few
are, in fact, arm’s-length auctions in substance or form. Yes, businesses
like eBay or Priceline conduct Internet auctions for products and ser-
vices ranging from broken laser pointers (the fi rst item ever sold on
eBay) to hotel rooms, but their share of overall commerce is small.
8 Introduction
Many transactions in modern industrial societies remain “closely embed-
ded” in ongoing relations (or “networks” of such relations),
5
as sociologist
Mark Granovetter wrote in 1985 in a seminal article. We consult the
same physician, have our hair cut by the same barber or hairdresser, and
report to work every day to the same boss—unless we have compelling
reasons to switch. These ongoing relations not only help protect against
malfeasance and fraud, as Granovetter emphasized, but also coordinate
decentralized initiatives. Relationships between engineers at Apple and
engineers at its suppliers of hard drives, for example, help both sides
align their plans for new products.
N
ow we come to two observations that are more controversial. The
fi rst is about the role of governmental laws and regulation, and
the second about the division of the fruits of progress in a capitalist
economy.
Advocates of free enterprise often take a dim view of government
intervention in the economy. Many believe that governments should
protect citizens from physical harm and enforce property rights, but that
doing much more is futile or, worse, harmful. Enterprising individu-
als will fl out the rules—ignoring speed limits and using radar detectors

to thwart the highway patrol’s efforts to catch violators. Rent-seekers
go further, manipulating the state’s coercive power for their private
gain: A small number of sugar growers, for instance, can raise the price
everyone pays for sugar by lobbying for tariffs on imports.
This hostility toward more rules probably helps nurture the belief
that capitalism is an anything-goes, practically lawless system. I argue,
however, that in a dynamic, decentralized economy, an expansion of the
role of government is inevitable and two-sided: Technological advances
often require an expansion of the government’s role; they also create
opportunities for injurious rent-seeking (see box). To fi gure out whether
a particular expansion is desirable or not requires a judgment that takes
specifi c circumstances into account.
An Inevitable Expansion
Arguments about the extent of the powers of the state predate modern
capitalism. Leviathan, written by Thomas Hobbes during the English Civil
War, which broke out in 1642 and presumably framed Hobbes’s book,
Introduction 9
makes the case for a strong central authority: In a “state of nature” without
government or other social restraints, everyone can rightfully claim everything.
Inevitably, confl ict—a “war of all against all”—ensues, making life “solitary, poor,
nasty, brutish and short.” Individuals, therefore, enter into a social contract,
surrendering their natural rights to an authoritarian sovereign in exchange for
protection against disorder, and even accepting some abuse of power by this
authority as the price of peace.
Classic liberalism, as exemplifi ed by Adam Smith, took the opposing view:
“Repressive political structures” in Granovetter’s characterization of the liberal
view, “are rendered unnecessary by competitive markets that make force or fraud
unavailing.”
6
Even informal social associations can do more harm than good by

facilitating collusion (“conspiracies against the public or in some contrivance to
raise prices,” as Smith put it) that weakens the discipline of competitive markets.
To the extent competition doesn’t fully do the job, innate sentiments such as
empathy step in.
The U.S. Constitution and other governmental arrangements established
after Independence followed the principles of classic liberalism rather than
Hobbes. But then, especially in the twentieth century, the role of government
and the resources it controls increased to an extent that would have astounded
the Founding Fathers. Many public choice theorists suggest that such expansion
is the inevitable and unfortunate consequence of lobbying by special interests.
Does this mean, then, that the Founding Fathers made a mistake in their
initial design, or does democracy inevitably lead to overbearing government?
And why, if the expansion of the government is so bad, was economic
growth in the twentieth century higher than in the nineteenth century, when
government expenditures and taxes were extremely low—there was no
income tax, except during the Civil War—and no federal bureaucracy to
impose minimum-wage laws, regulate health and safety standards, or resist
monopolies and trusts?
At least some of the expansion in government, I suggest, has occurred
because technological advances increased what most people would consider its
minimal roles on a variety of fronts.
The transformation of U.S. society from agrarian to industrial created the
need to defi ne and enforce new kinds of intellectual property, for instance.
Initially, this regulation consisted of patents on “inventions”; then, as economic
activity became more specialized and diverse, the scope of what was regarded
as intellectual property expanded to include brand names, logos, designs,
software code, and even customer lists. Legal protections had to be defi ned
and enforced for such property through new state interventions such as
broader copyright rules,
7

the policing of counterfeiting, and the expansion of
common laws governing trade secrets.
New technologies created the need for rules to coordinate interactions
between individuals or groups. The invention of the automobile, for example,
necessitated the formulation and enforcement of driving rules and a system of
vehicle inspections. The growth of air travel required a system to control traffi c
10 Introduction
and certify the airworthiness of aircraft. Similarly, radio and television required
a system to regulate the use of the airwaves in order to avoid the collision of
signals by competing broadcasters.
Modern technology created new forms of pollution that didn’t exist in
agrarian economies. Governments had to step in to make it unrewarding to
pollute. Likewise, antitrust laws to control commercial interactions and conduct
emerged after new technologies created opportunities to realize economies
of scale and scope—and realize oligopoly or monopoly profi ts. These
opportunities were largely absent in preindustrial economies.
But even if what governments should do increases with technological
progress, this does not mean we should embrace the opposite principle that
that government governs best which governs most. New technologies not
only create real needs for new rules, they also generate more opportunities
for unwarranted meddling and a cover for rent-seeking. It’s one thing for the
Federal Aviation Administration to manage the air traffi c control system, quite
another for the Civil Aeronautics Board (b. 1938, d. 1985) to regulate airfares,
routes, and schedules. The construction of the Interstate Highway System may
have been a great boon to the U.S. economy, for example, but it did not take
long for Congress to start appropriating funds for bridges to nowhere.
In other words, government matters a lot in advancing or sabotaging progress.
The right question to ask isn’t whether there is too much or too little intervention
in the abstract, but whether a specifi c policy or law is of the right kind.
The inevitable efforts to game the rules aren’t an argument against

introducing new rules when changes in technologies or social arrange-
ments so require. An assessment of how much gaming—or outright
cheating—is likely, and what would be required to control it, should,
however, be an important consideration.
Interested parties will lobby to shape new rules to their advantage;
in an open, democratic society that protects freedom of expression, there
is no way to stop this effort. In fact, lobbying by competing interests can
help shape rules that are, on balance, good, or lead to the discarding of
bad rules. That said, people are no more prescient about rules than they
are the about their customers or competitors, so the canniest business-
people or lobbying groups can mistakenly resist rules that are in their
best long-term interest and ignore ones that pose mortal threats.
These mistakes will play an important role in the story I tell in this
book.
T
he technological advances that dynamic capitalism unleashes help
make some people richer than others and may allow a few to lead
Introduction 11
exceptionally opulent lives. Many new technologies amplify differences
in material rewards that arise from differences in individual talent, tem-
perament, and luck. When agricultural technology was relatively primi-
tive, a settler who received title to 160 acres under the Homestead Act
could expect to make roughly the same living from farming as his neigh-
bor. With modern technology, however, farmers who have the ability
to use tractors, harvesters, hybrid seeds, crop rotation techniques, and
futures markets to hedge their output—or have good fortune in their
choices—can earn signifi cantly higher returns than those who don’t.
Similarly, businesses that realize economies of scale in producing trac-
tors can be much more profi table than the craftsmen who made plows
or the blacksmiths who shod horses.*

This does not mean, however, that developers or users of innovations
secure great wealth at someone else’s expense. “Behind every great for-
tune lies a great crime,” the old saying goes,
8
but it is rarely true in capi-
talist life today, especially on the innovative trails. Rather, entrepreneurs
who make large fortunes through technological advances create much
larger benefi ts for users of their innovations (see box). The rising tide of
capitalism raises a great many boats, and some happen to be yachts.
Who Benefi ts? (and Contributes?)
New products and services usually generate value to users considerably in
excess of the price. If they didn’t, why would customers take a chance on a new
product or service? The threat of competition also encourages innovators to
cede much of the value to their customers.
9
Of course, the large users’ total shares may be obscured by the relatively
small individual amounts: Successful innovators, such as the founders of Google,
can secure extraordinary wealth, whereas the dollar value that goes to a single
user is often quite small; therefore, it is tempting to think that innovators are
the main benefi ciaries. But users outnumber innovators by a wide margin—tens
of millions of individuals and businesses benefi t from Google searches—so
small amounts add up to a lion’s share of the total. For instance, Yale economist
*Chicago’s Frank Knight apparently had similar and fi rmly held beliefs:
George Stigler (1985, 6) has written that Knight tenaciously stuck to the view that
a “competitive enterprise system inherently leads to a cumulative increase in the
inequality of the distribution of income . . . [A]t countless lunches this was challenged
on both analytical and empirical grounds by Milton Friedman, each time leading
Knight to make temporary concessions only to return to his standard position by the
next lunch.”
12 Introduction

William Nordhaus analyzed data for the nonfarm business economy and for
major industries in the United States. He found that producers captured a
“minuscule” fraction of returns (on the order of 3 percent) from technological
advances over the period from 1948 to 2000, “indicating that most of the
benefi ts of technological change are passed on to consumers.”
10
But consumers aren’t just passive benefi ciaries. Their venturesomeness—
manifested, for instance, in their willingness to take a chance on unproven
products and their resourcefulness in using them—plays a crucial role in
realizing the value of innovations. Indeed, a great strength of our widely
diffused and decentralized system of innovation lies in harnessing the talents
of a large number of individuals and rewarding them for their contributions.
In the nineteenth century, new products were developed by a few individuals.
Edison brought forth a remarkable cornucopia—incandescent bulbs, motion
pictures, and gramophones—from a small facility in Menlo Park (New Jersey,
not California) with fewer employees than the typical Silicon Valley start-up.
Alexander Graham Bell had one assistant. Such small organizations couldn’t
quickly develop good products at affordable prices, so many inventions were,
at the outset, playthings for the rich. Now, because of a widely inclusive
system of innovation, products like iPods and netbooks hit mass markets from
the get-go.
A Dangerous Divergence
Doesn’t the unsparing global economic crisis we have witnessed shred
this cheerful sketch of modern capitalism? I argue that it does not.
Modern fi nanciers often regard themselves as über-capitalists, but,
in reality, fi nance has drifted well away from the practices that make
capitalism successful, and toward the caricature drawn by its critics.
Consider just a few of these vanishing features.
The fi nancial system has been giving up, albeit unwittingly, on the
decentralization of judgment and responsibility. Case-by-case judg-

ments by many, widely dispersed fi nanciers with the necessary “local
knowledge” have been banished to the edges, to activities such as ven-
ture capital (VC), which accounts for a useful, but tiny proportion of
fi nancing activity. The core is now dominated by a small number of very
large fi rms that have little direct contact with the ultimate real users or
providers of fi nance.
Case-by-case judgment has also retreated. Instead, fi nanciers rely
on centrally designed, mechanistic models that cannot take local varia-
tions into account. The use of blind diversifi cation has also grown, not