AG: And this has been institutionalized to some degree, has it not?JM: Yes, it has. There are a lot of firms, such as accounting firms that do audits, credit rating agencies, and investment banks that do underwriting, whose very existence traditionally has been explained by the fact that they’re reputational intermediaries. Companies in search of capital will guarantee that they’ll be audited by a major accounting firm; or be rated by one of the best agencies, like Moody’s or Standard and Poors; or to have underwriting by a bulge bracket investment firm like Goldman Sachs; and to be listed on the New York Stock Exchange or the Nasdaq. People look at those “Good Housekeeping” seals of approval and think they can trust the main street company coming into the capital market. That business model had a lot of explanatory power even just twenty years ago. But it seems almost farcical today. So this book is basically a journey in which I try to figure out what happened to that theory, which I call the traditional economic theory of reputation. AG: That’s fascinating because it vibrates or harmonizes with many observations other people have made, with which I’m sure you’re very familiar. Trying to figure out why this has happened is a difficult task because it probably involves several layers of causation. But one thing that strikes me right away, even though I am hardly expert in this subject, is the well-known observation that twenty or so years ago most people who bought stocks held them for relatively long periods of time; they were interested in the long-term dividend value of the stocks. But gradually, and then not so gradually, people began holding stocks for much shorter periods of time because they were mainly concerned about the share value, not their long-term dividend payoff. Of course, if you’re the manager of a business, the way you conduct yourself in these two scenarios is very different, and that, it seems to me, has implications for reputational capital. JM: I agree completely about the time horizon of investors, and it’s important to identify the reason for the change. One is that our regulatory system, particularly the tax system, penalizes the long-term investor and rewards the short-term one, because of the punitive taxes on dividends and capital gains, and the dodgy way venture capital firms are taxed. Another major factor is that many investments are not purchased so much as sold. In other words, investment bankers tell potential customers a story, and hope that the story they tell—which often involves short-term profits—will cause people to invest. Wall Street makes most of its money on short-term investments. Long-term investors are, by definition, not very profitable for financial intermediaries. So the hard sell goes into creating day-traders and people who are willing to put up with very high turnover in their portfolios. AG: Right, it’s transactions and commissions and fees, and things like that, that make these firms rich these days. JM: That’s absolutely right. AG: There’s another piece of harmony I want to ask you about, which suggests to me that this is all of a piece with some deeper trends. Before computers and the internet, stockbrokers and people who sold bonds were able to profit and prosper based on segmented markets because information was not readily available to everyone. So they could get an eighth of a point as a commission fee because the average buyer didn’t know the information that the traders and bond sellers knew. As soon as information became free and widespread, it put these people out of business, pretty much. If they wanted to stay in the finance business, they had to find some other way to do it, some other service to sell. It seems to me that the same technology that put them out of business in due course enabled them to repackage risk and accelerate transactions, finding a new way to make a living when the old way became obsolete. So I want to ask you about the role of technology in all this. Isn’t it true that the pace of transactions has been mightily accelerated by technological innovation? And what happens to reputational capital when, in a sense, it gets mechanized and depersonalized? JM: Yes, that’s true; technological change matters enormously, and there are many illustrations of this. One is that spreads are narrowing. As you say, technology has democratized innovation, and this has made it much harder for anyone to make a profit with a trading strategy. Whatever information one group is using to fuel a trading strategy has also been shared with lots of people (unless, of course, we’re engaged in illegal insider trading). So as a consequence of this we see much bigger investment in trading technology, in an attempt to outrun the pace of technology, which I think is a waste of resources and a fool’s errand. We see that Wall Street has to either shrink dramatically or engage in edgy, borderline shady transaction. AG: That suggests something else interesting: that the advantage goes to the first person past the post, in a winner-take-all scenario. Whether you finish third or thirtieth doesn’t matter much these days. It seems to me that you’re suggesting that the temptation to insider trading must be greater, because the relative advantage it brings is greater. JM: I agree with your bottom line, but I would articulate it slightly differently. It used to be that you could make money on Wall Street without engaging in insider trading. For many businesses on Wall Street that’s no longer the case. So it’s not just that the rewards are greater, but that the market has become so efficient that in many sectors it’s the only way to make money. AG: I want to go back a bit and ask about your comment that the tax code penalizes long-term investment, since dividends are taxed at a different rate than capital gains. But my understanding is that you don’t qualify for capital gains unless you’ve held an investment for at least a year. Can you explain a little more about the difference between holding an investment for dividends for five or six years—say, $1 million—versus holding it for just the one-year requirement to get to the 15 percent capital gains. How does that work out in terms of tax advantages? JM: I think that the tax rate on capital gains, even short-term capital gains, is about 28 percent, and that’s lower than the rate on dividends. So the longer you hold it the better the tax rate. But even short-term capital gains still tax favorably. AG: Let’s talk about the cultural shifts behind this. David Stockman, in his book The Great Deformation: The Corruption of Capitalism in America, described the problem in part as a short-term “flip it” mentality. There’s no sense of community bonds; the people you’re getting your mortgage from might be 2,500 miles away from you; and there’s no face-to-face interaction or personal boundaries to stop people from being scurrilous. There’s a question of scale here as well as technology. We’re talking about a mentality with no sense of intergenerational responsibility, let alone communal responsibility. How did this happen? What broader trends in the culture do you think brought this about? JM: One cause is that it’s no longer considered to be true that there’s a single shared sense of ethics and responsibility. It used to be that people would have a reputation—a single, unitary reputation. Now, people can have a lot of reputations. These traders on Wall Street, for example, may be viewed by many as scurrilous and completely devoid of any moral system of constraint. But the more money they make, the more people they rip off, the more well-respected they are by their colleagues. I hate to sound like a right-winger, but the right wing has a point on this—we now live in an era of moral relativism in finance. What twenty years ago everyone thought was abhorrent is now considered acceptable. That’s true even at the extremes of insider trading. There was a time when insider trading was considered the finance equivalent of child molestation. Nowadays, however, we hear, “it’s just a technicality”, or “I didn’t really do anything wrong”, or “I got this information legitimately” or “well, who knows where to draw the line?” Part of the change has to do with how society has become much more diverse and complex. But regulation has also really hurt. The SEC’s lawsuits used to have a real shaming effect. Now, because the SEC has sued every major financial firm, litigation, at least by the SEC has lost that shaming effect, and that’s really unfortunate. Certainly, the fines the SEC levies are no meaningful deterrent, given the low probability of detection. So once these measures have lost their sting, there’s not much constraining effect associated with the SEC’s enforcement agenda. AG: It’s like a slap on the wrist. Take the still fairly recent HSBC case; it was fined about $1.9 billion, and that’s barely pocket change for that bank. JM: Yes, and there’s no admission or denial of guilt, so it’s literally considered to be a tax. If they make enough money on the underlying activity, you just estimate the tax and multiply it by the probability of detection and make a decision going forward. It’s not what we would call a fine in the traditional sense of the word. AG: It reminds me a little of the Bob Dylan line, which I am probably quoting inexactly: “Steal a little and they throw you in jail. Steal a lot and they make you king.” JM: Exactly, except they’ll make you CEO. AG: Right, it’s almost a badge of honor to be sued by the SEC nowadays. JM: That’s not the case with being sued by the Justice Department, by the way. There are some heroes to this story, and the Justice Department has been great lately. They’re bringing a lot of insider trading cases, and they sued Standard & Poor, which was sort of the SEC’s job. AG: Well, it took them long enough. Why did it take them four years to do this? JM: That’s an interesting question. One wonders why it took so long, why the charges were civil and not criminal, and why S&P and not Moody’s. I had a student do some research about this. I said to look at the SEC’s complaint, look at the deals S&P is being sued over, and see if there’s any difference between the way that S&P rated these guys and the way Moody’s did. Turns out, there’s 100 percent overlap. There’s no principled basis for distinguishing them. AG: So what’s your theory of this particular case? I smell politics. JM: Well, the conspiracy theorists are saying it’s because S&P was the one that downgraded the U.S. credit rating. I can’t bring myself to believe it, but it fits the facts. AG: I’m not a conspiracy theorist; but I also don’t believe in those kinds of coincidences. If someone were to put the case before me, though, I have an open mind about it. Anyone who has worked inside the government, especially in the White House, knows that truth can be a lot stranger than conspiracy-theory fiction. It’s not beyond the realm of possibility. Let me ask you something else, related to Robert Putnam’s book Bowling Alone, about the demise of social capital. JM: I’m a huge fan of that book. AG: Me too, and so is my colleague at The American Interest, Frank Fukuyama, who wrote a book about trust many years ago. JM: I love that book, too. AG: So let me enter some sensitive territory. You mentioned earlier the sort of self-monitoring or gatekeeping, function that the high business class of the United States has performed. This wasn’t always true in our history, of course. There were plenty of shenanigans in the first Gilded Age, after the Civil War, for instance. But starting in the early 20th century we had these gatekeepers, who mostly ran in families, or neighborhoods or cliques. And let’s face it, most of these people, back in the time before the Vietnam War and the counterculture, were Protestants—a good number of them were Episcopalians. The argument has been made that they shaped a consensus about what was or was not considered “unseemly”—a word you almost never hear anymore. Then, this group of Protestant elders, those related to the pre-revolutionary settlement cultures, especially in New England and the mid-Atlantic region, pretty much abandoned their position. They felt guilty about what they had allowed to happen in the country, whether it was about Indians or slavery or what-have-you, and the Protestant gatekeepers essentially abandoned their posts. As you mentioned, now we have a much more diverse, heterogeneous society, and into those roles have come a whole range of people who don’t have as much in common with each other as did the old Protestant establishment. And their general sense of what is or isn’t “unseemly” isn’t the same as it was before, say, 1965, to pick a year not entirely at random. Of course, you’re not allowed to make arguments like this anymore. But I just made one. What do you think of it? JM: Well, I don’t think that Protestants or old Yankee families are any worse or better than anyone else in an abstract moral sense. But there are certain facts about this group that are worth noting. There used to be a class system in the United States much more so than there is today. Think of the old adage, “And this is good old Boston/The home of the bean and the cod/Where the Lowells talk only to the Cabots/And the Cabots talk only to God.” One could have a tremendous amount of prestige and power without having a lot of money. In fact, having too much money and being gaudy with it was considered gauche. So I don’t think it’s that Protestants have changed; it’s that the culture, and the incentives under which these group operate, has changed. To say you’re Henry Cabot Lodge IX is no longer as cool as it used to be. To be part of Skull and Bones at Yale or the Porcellian club at Harvard is no longer such a big deal. It’s no longer as prestigious to be noble and have principles, but not be the richest person. We’ve come to the apogee of the “meritocracy ideal”, which is that prestige and class are tied to how much money you have, and if you only earned it last week, that’s just fine. Now, that’s not necessarily a bad thing. Having a more horizontal, less class-based society is a good thing. What I find unfortunate, though, is that we still have prestige demarcations and gradations, and the measuring stick appears to be money. The religions that are most respected are the ones with the most money, as are the bankers and doctors. I was at dinner recently with a friend of mine, a neurosurgeon, who just had a hip replaced. He said his orthopedic surgeon makes a lot of money, and that’s how you can measure a good doctor. I found this a disconcerting statement, but a sign of the times. AG: I think both of these things are true. It’s true that the cultural changes have affected these groups. I also think that they abdicated. You’re right that there are a lot of bad things about a hierarchical, class-based society, but there are some good things about it, too. A Boston Brahmin banker years ago, whether he was very wealthy or just merely wealthy, wouldn’t do unseemly things because not just his business was at stake, but his whole family reputation—who his daughters could marry, for example—was at stake. JM: Exactly right: He would lose what really mattered, and be ostracized. One can imagine such a world without exalting any particular religious group. I’m not saying we should go back to that kind of time, but it would be a great thing for this country if shaming and ostracism were attached to some of the shady practices going on. What was great about the period of WASP domination wasn’t the WASPs as such, I think; it was the very strong incentives for people to behave in a forthright and honest way. AG: That’s right, of course, but I still think specific religious cultures exhibit certain traits. As you mentioned, for example, rich people years ago weren’t so ostentatious. I think that derives from the Protestant ethos. You may be a Calvinist and believe your riches are a function of your grace, but you don’t go showing off in public. Nowadays the level of ostentatious consumption by wealthy people is obscene. JM: We sometimes go to Martha’s Vineyard during the summer, and it’s unbelievable what people are building there. It used to be a quiet WASP enclave, and now there’s a battle to build the biggest mansion you can. There are these monstrosities that are only built to show off that a person has a lot of money. AG: Yes, in Potomac, Maryland where I live (in a house that started out during the Jefferson Administration as a log cabin), people call them McMansions. Anyway, say what you will about noblesse oblige, but people used to think they had an obligation to give back to the community. Most high-rollers today appear to believe no such thing. They have no reputation barometer. JM: Some do make donations, but it’s not to give back to the community so much as to send a signal. Gifts are very public. You hardly see an anonymous gift anymore. AG: So, to conclude, what does it mean when someone like Enron’s Jeffrey Skilling can be released, as may soon happen, having served only about 30 percent of his sentence? But if some poor young guy gets caught selling marijuana to an undercover cop, he’s screwed maybe forever. JM: I think there’s an extremely high probability that Skilling will get out early. There is no question that the only reason is that he has a lot of money to buy the best possible defense, and his lawyers kept filing one motion after another. To the extent that he gets out of jail, it will demonstrate that we have an unequal system of justice with regard to wealth. AG: I don’t think there’s any question about that. In my latest book, Broken, I tried to lay out an inclusive taxonomy of plutocracy, in five categories. One of them had to do with the capacity to torque the judicial system, and as a subcategory of that, to torque the tax code. That’s one of the main shovels plutocrats use to dump money into their bank accounts. JM: If you’re rich and powerful enough to be on the same side as Goldman Sachs in trades rather than a counter party you’ll make money and won’t risk losing. Take the ABACUS deal with John Paulson. The people who traded on Goldman Sachs’s side made a lot of money, and the institutions on the other side lost a lot of money. AG: One more question, if I may, about your students at Yale. They’re in their early twenties, right? When you talk to them, and refer back to the way things were, say, twenty or thirty years ago, it must seem to them as if you’re talking about the Peloponnesian War. So when you talk about the value of reputation, or even the value of being greedy in the long term, do they understand what you’re talking about? JM: That’s a good question. I’ll have to ask them. They understand certain aspects of reputation, but not in the way you and I are talking about. AG: Last of all, please: In 19th-century Britain there was a phenomenon called “bill broking”, which involved a group of middlemen who really knew well the reputations of the merchants in given commercial areas. They would buy debt at a discount and would pay off the person whose money was due and then arbitrage the difference to make a profit. In order to be successful at this, bill-brokers had to know well who was going to pay off and who not, and intuit the outcome. Walter Bagehot wrote famously of this. JM: There’s a phrase for this in finance, or at least there used to be: “character loans.” AG: Reminds me, too, of J.P. Morgan’s famous criteria for loaning money. JM: Right. There are no more character loans, as best I can tell. And, for better or worse, no more people like J.P. Morgan, whose reputation made the man. AG: Thanks, Professor Macey: I look forward to reading the book.
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Published on: June 6, 2013The End of Reputation
The Death of Corporate Reputation: How Integrity Has Been Destroyed on Wall Street by Jonathan R. Macey (FT Press, 304 pp., $39.99)
AG: So what’s the basic thesis of your book, and what motivated you to write it?
Jonathan R. Macey: The basic thesis of the book is that the business model of firms on Wall Street, including accounting firms, investment banks and accounting agencies, no longer takes into account or values investment in reputation. The book explains why this is the case and what can be done about it. I was motivated to write it because I teach law and economics at Yale, and among the concepts that I teach is the economic theory of reputation. It posits that profit-maximizing agents will invest in their reputation up to the point at which the cost of doing so is equal to the expected benefit. It’s rational, in other words, to care about what others think of you.