David R. Henderson  

Henderson on Zingales

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My review of Luigi Zingales's book, A Capitalism for the People, has been published in the latest issue of Policy Review. One of the best parts of his book is the content on cronyism. In case you think this review is an instance of cronyism, it isn't. I completed it in June and found out only months later that Luigi would be a guest blogger. Also, I do make criticisms of the book in my review. Here's an excerpt from my review:

"No man is a prophet in his own land" goes the saying, and one reason why Zingales's message is fresh is that, coming from a country with a great deal of cronyism, he sees just how stultifying cronyism can be. Zingales contrasts Italian cronyism with U.S. meritocracy. He points out that the way to get ahead in Italy is to "carry the bag" of an established person. Even emergency room doctors are chosen, he writes, based mainly on political affiliation rather than on skill. By contrast, in the United States, many more people get ahead based on their merit. Zingales tells the story of a young colleague walking in the rain with a senior professor. The senior professor told the junior one, "In Europe, the young assistant professors carry the umbrella for the senior ones." The young professor shot back, "Why don't you go to Europe?"

But Zingales sees all of America going in Europe's direction. He gives many examples of U.S. influence peddling. One of the most striking examples, because of the prominence of the person involved, is that of Robert Rubin. When Rubin was Treasury secretary under President Bill Clinton, Citigroup acquired the Travelers insurance company. That move was illegal, but Travelers' ceo Sandy Weil explained that he had had enough discussions with the Treasury and the Federal Reserve Board to "believe this will not be a problem." Rubin lobbied for a change in the law to make Citigroup's action legal after the fact, and in July 1999, the House of Representatives passed the law. The next day Rubin quit as Treasury secretary. Just three months later, Citigroup hired Rubin at a salary of $15 million, without, writes Zingales, "any operating responsibility."

It soon became clear, though, what was part of Rubin's responsibility: to play an inside game with the Treasury bureaucracy to benefit his new employer. In 2001, following revelations of "accounting irregularities" at Enron, Citigroup, a major holder of Enron's bonds, would have lost a lot of money had Enron's bonds been downgraded. So Rubin lobbied Peter Fisher, undersecretary of the Bush Treasury, to "advise" the bond-rating agencies not to immediately downgrade Enron's debt. And in 2008, the Wall Street Journal reported that Rubin had been "critical to securing the latest federal bailout of Citi." The bailout included two "equity infusions" totaling $45 billion and a government guarantee on most of the risk in a $306 billion asset portfolio. This is cronyism writ large.

Zingales's expertise is in finance, and that fact is apparent throughout the book. He tells, for example, of a tiny section of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act that destroyed Lehman Brothers. Under the law, when Lehman went bankrupt, it couldn't simply, as it could have before the 2005 law, pay holders of derivatives as much as possible with its assets. Instead, it had to give a derivative holder a contract identical to the one it had signed with Lehman, but with a different counterparty. Lehman would have to pay the transaction cost of the new contract. A typical such cost is about 0.15 percent of the contract's total value. That doesn't sound like much until you realize that when it went bankrupt, the face value of Lehman's derivative contracts was $35 trillion! So the transactions costs alone were $52.5 billion. That's why Lehman's bonds paid only 8.625 cents on the dollar.


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