Financial Markets (2011)

ECON 252 (2011) - Lecture 22 - Public and Non-Profit Finance

Chapter 1. Organizations Supporting Individual Causes [00:00:00]

Professor Robert Shiller: All right. For this, the penultimate lecture for ”Financial Markets,” I wanted to talk about nonprofit and government finance.

So, let me first recall some of the basic themes of this course. Finance is really about incentivizing people to do good work, and managing risks. These issues are not confined to the private sector, to the business sector. They’re very deep and central problems to all people.

The big problem–I’ll put it in the most broad terms–just about everything that we do that’s good is done as part of a team. It’s hard to think of something that you alone can do. And so, the problem with teams is that people have their own individual concerns and incentives, and doesn’t always yield teamwork.

So, that’s what I think finance is really about. You might think, I’m wrong, and some of the greatest achievements in history were done by single individuals. So, I don’t know, what you might think of. What comes to my mind is, how about Albert Einstein, all right? His theories, he was sitting in a patent office in Switzerland, and just doodling on a piece of paper, and came up with the whole theory of relativity. But you see, that would be a mistake to think that, because, in fact, he had gotten a PhD in physics from the Zurich Polytechnic, which is a nonprofit organization. And he relied on journals of physics. He could not have done it, if he didn’t read what other physicists were doing. And journals were organizations that had financing, I assume nonprofit.

But I thought of another example. Charles Darwin, the great physicist–not physicist, the great naturalist. People point out that he wasn’t affiliated. He was on his own, he wasn’t part of a university. I guess, he got financing, but kind of on his own. But he couldn’t have written The Origin of Species by himself. In fact, he got financing from private donors for the Beagle. You know, this two-year voyage he made around the world, where he collected specimens and information? And actually, he goes back to his professor. He had a Professor Henslow at Cambridge University, who was a botanist. And Henslow arranged for Darwin’s voyage and sent him off.

So, these are organizations that–I don’t think, you can do much good [addition: without the support of any organization]. Some people say, well, how about a poet? A poet? Even Homer was a blind poet, right? He didn’t have anything. He memorized everything. He didn’t even write it down, he just memorized everything. He just sat there and thought. But even he must have had financing, because he traveled around the world of his day and made his poems known, otherwise they wouldn’t survive. Other people learned them. He must have had financing for this. It must’ve been a business. So, that’s the general theme.

I’m going to talk today–there’s so much to talk about–I’m going to try to see, how much of this I can cover well. I want to start by talking about nonprofit organizations. These are organizations, which have a purpose stated in their charter other than making money. And then, I want to talk about government involvement in for-profits, that for-profit companies are not completely clear of a social interest as well. Then, I’m going to talk about government finance of projects, and then finally, government social insurance.

I’m hoping, that this lecture will remind you of things that you can do, because in all these sectors there are things that you can do. But one of the themes of this course was, you should have a purpose in life, and it should not be making money, per se, and think of finance as a tool that you can use to help you achieve this purpose. So, that’s what I want to talk about.

Let me start, then, with nonprofits, OK? A nonprofit organization, it can be corporation, that is an organization set up to for a charitable cause or a good cause, and it has no owners, in the sense that there’s no shareholders. The profits go back to the organization for its purposes. So right now, you’re sitting–as I mentioned before, Yale is a nonprofit. It has no owners. It’s a person, a legal person in itself. But it has a board of directors.

In the United States in 2010, there were 1.6 million nonprofits. It’s huge. The U.S. is probably the country that has the strongest nonprofit sector. My number for the United Kingdom may be out of date–it was 120,000. It’s part of the U.S. culture, that nonprofits are big. It goes back to the founding ideas of this country, that we don’t have a government running everything. We do things on our own, on our own initiative. Of course, it’s not just the U.S. There are nonprofits in every country. But that’s a lot of nonprofits. And they recently accounted for about 4% of gross domestic product [in the U.S.]. So, OK, it’s not huge, but it’s a very important component of gross domestic profit [correction: product].

Chapter 2. Nonprofits: Pursuing Common Interests [00:06:45]

I just want to start by thinking about nonprofits, and maybe put the idea in your head of creating one at some point in your life, sooner or later. I thought, I’d start with some examples, that are familiar to me, of nonprofits. When you’re thinking of some activity or some idea you have, you can set it up as for-profit or nonprofit. And let’s just think about why you would do that.

So, I’ll give you an example. Peter Tufano–he’s a professor at the Harvard Business School–set up a nonprofit on his own, just as a professor. I know him. And he gave it an inspirational name, Doorways to Dreams, OK? And it’s about personal finance and about helping people do things better in their personal financing. So, one of his ideas–and he raises money for his foundation to promote it–one of them is to have an automatic check-off on the tax form, so that, when you get a tax refund, instead of getting it in cash, it could go right into U.S. savings bonds to encourage people to save, all right? This is based on Behavioral Finance, and the fact that a lot of people, especially lower income people, don’t save. A little nudge like that would help them save.

Another thing, this sounds like a strange idea, but this is the kind of thing he can pursue on his own genius, as long as he can raise money to get them to do it. He has the idea that a lot of people like to play the lottery, OK? Obviously, they do. And they just are steady losers on this. You know, on average, they’ll always lose. But given that people want that, why don’t we create savings plans that pay out randomly, like winning the lottery, so that the government doesn’t have any take in it, it just encourages saving.

That’s a strange, original idea, which you might find–I don’t know if I defended it well enough to you–you might find it hard to convince the government to do it, but he can just do it. He doesn’t have to talk to the government. He talks to individual banks, and he’s gotten some now to offer this plan.

But what was striking to me is, he said, when I go into some company trying to raise money for my projects, when I tell them I’m nonprofit, it changes the whole atmosphere, because they know that I’m not profiting from this. And so, it opens up opportunities.

I’ll give you a second example. Dean Karlan here at Yale–he came here as an assistant professor. In 2002, he created a charity called Innovations for Poverty Action. So, Dean Karlan. Some of you may have taken his course. Anyone took his course? Some of you, yes. Actually, the doorbell rang at my house here in New Haven, and a young woman was collecting money for charity, and it was his charity. I was shocked. He’s actually sending people door to door, at least as part of his course.

But since then, he’s developed–again, when it’s nonprofit and it’s aimed at alleviating poverty, he can bring in lots of money. So right now, last year, in 2010, the income of his Innovations for Poverty Action was $25 million. And he has a staff of 500 people all over the world, operating in a lot of poor countries. That’s a couple of examples that are familiar to me, because they were set up by friends of mine.

Another example. This is Bill Drayton. He set up something called the Ashoka Foundation. Ashoka is a Hindi name for–what is it–it’s a ruler of India, who advocated non-violence and philanthropy. And he went to Yale Law School, as well as Harvard College. So, sort of local here. But it’s been a huge success, and it encourages sort of entrepreneurship, or social entrepreneurs. But he didn’t stay on as a professor. He taught at Stanford Law School, but dropped out, because he wanted to pursue his nonprofit. I’m amazed that these two guys can be both professors and running big nonprofit shops as well, some people can do that.

My last example is Wendy Kopp. I like this example for your age, because her story starts with her senior essay. Do you know this story? She was an undergraduate at Princeton, graduated in 1989, and she had to write a–maybe they call it a senior thesis. And so, she wrote something about education, that she had an idea, that often it’s hard for elementary education to find people who are passionately committed to science or mathematics or other fields, because these people typically don’t want to devote their lives to teaching. But they might devote a couple years to teaching. And so, she thought, that it would be a good idea to get people, when they graduate from college, to spend a year or two in elementary education, and that it would be refreshing and good for the educational system to get enthusiastic young people, who are really interested in the disciplines.

So, that was her senior thesis. Now of course, you can’t get the government to pay for that. Maybe you could. It might be hard, because, well, the teachers union might not like this, or they might–you know, it’s sort of a controversial idea. Some people would say, someone, who’s taken a course in mathematics at Yale University, is really not qualified to teach young children, because he or she didn’t take the educational curriculum. And that’s always going to be controversial. But here, where we live in a society that emphasizes nonprofits, you don’t have to convince the government, all right? You convince anybody to finance this, and you can do it.

So, right out, she was 21 years old, she graduated from Princeton, she raised $2.5 million in her first year to set up an organization, called Teach for America. And the organization merely recruited young people, who had just graduated college, to go into teaching. So anyway, that’s become her life’s work in the 20-plus years since. She’s heading what she created.

I like this story, because some of you are writing senior essays, right? And you should consider it as a model for some–you might consider it as a model for some great idea, that you might have, that you could carry to the world. And one way to make it happen is, if it’s that kind of idea, you just set up a nonprofit right there.

Actually, I wanted to give you some other examples. In New Haven, we have two major hospitals, OK? Where did they come from, and why do we have them? Well, one of them is called Yale New Haven. So, how did that get started? Well, it was started by a nonprofit in 1826, called the General Hospital Society of Connecticut. Back then, there weren’t many hospitals, and so, someone set up a nonprofit to set up a hospital, and it was then the only hospital in the state of Connecticut, and so they called it State Hospital. Later, as more hospitals appeared, it didn’t seem good to call it State Hospital anymore, so they changed the name to New Haven Hospital. That was in 1884. And then, in 1913, they joined with another nonprofit called Yale University, and then later, they changed their name to Yale New Haven Hospital. But it’s been a nonprofit all the time. There are for-profit hospitals, but this one was always a nonprofit.

The other hospital that we have in New Haven is St. Raphael’s, and that’s newer. It was created in 1907, and the story is, that a group of physicians from the New Haven area thought we needed a second hospital, and they went to Sisters of Charity [addition: Sisters of Charity of Saint Elizabeth], which is a–I don’t know much about them, it’s a nunnery, I suppose–and worked with them to create a second hospital. And they chose the name Raphael, after an archangel recognized by many faiths, which means God has healed.

Interesting to think about this hospital. So, whose idea was it, and how did it happen? Well, apparently the idea wasn’t from the Sisters of Charity, it was from physicians who were in New Haven. So, why did they go to the Sisters of Charity? Why didn’t they just set up a for-profit hospital? They could have bypassed them completely. What’s the link?

Well, I think that–I don’t know all of their reasons, but I’m suspecting the reasons are, that, when you affiliate with a religious organization, it gives a sense of moral mission and social purpose to the organization, that it wouldn’t have otherwise. And it makes it very clear that it’s nonprofit and encourages people to donate. So, I think that this same idea has dawned on many people. The people, who see a need for a new hospital, are probably not leaders of churches, but they see a common interest in pursuing hospitals.

There have been many studies about for-profit versus nonprofit hospitals, and who gives the better care. I think, that the studies are generally inconclusive, because even people, who are operating for-profit hospitals, have a social mission as well. They have morals. It’s not just churches. People outside of churches have morals as well. And so, the actual distinction between for-profit and nonprofit is often somewhat ambiguous.

Chapter 3. Government Involvement in For-Profits [00:18:55]

Let me move on to the second point, that I said I was going to talk about, which is government involvement in for-profits. So, governments exert control over both nonprofits and for-profits, and it’s often a difficult distinction between a government activity and a private activity, because of the regulation that governments impose over companies and the taxes they collect.

Let me first make it clear, that virtually every country of the world has a substantial corporate profits tax, and in that sense, governments are co-owners of corporations, private corporations. So, the corporate profits tax is in effect a sort of partial nationalization of all the private companies in the country. So, in the U.S., it currently stands at 35% federal, and up to 12% state and local, depending on the state. So, it’s as high as 47%–it’s basically half. So, you could say that the U.S. government has nationalized close to half of the private sector. The government is collecting from their profits, as if they were a shareholder. This is state and local.

But it’s the same in other countries, or similar. Canada, Ottawa collects 16.5%, and the provinces, up to 16%. A little bit lower than the U.S. Japan, the national government has a 40.6% profits tax. Brazil, 34%. You might think that under the Lula government, the recent Lula government, they would be more left wing, and would have a higher profits tax, but they don’t. It’s about the same. China is 25%. India is 33%. And I could go on and on. There’s almost no country that doesn’t have it. So in that sense, everything is part of the government. It’ about the same all over the world. And that’s because–I think there’s a reason for that–because if you charge too high a profits tax, then business will leave your country.

Why do we charge a profits tax? Well, I think the corporate profits tax is justified by recognizing, that this thing about for-profit or private always has its limitations, and anything that’s private is not completely isolated from other interests or activities.

I thought, it would be useful to think of one example. There’s a company called TEPCO. You heard of this company? I don’t expect that you would. It’s the fourth largest electric power company in the world, and it’s traded in the U.S. And you may own shares in it and not know it, because it’s such a big and important company. Or at least your parents, good chance that they own shares in it, because they probably own some diversified portfolio in their pension plan, or maybe they even have it set up in a trust for you already. So, don’t judge TEPCO too harshly.

All right. But let me just tell you about your investment in TEPCO. Guess what country it’s in?

Student: Japan.

Professor Robert Shiller: You got it. So, somebody knows.

Why would that matter right now? Big electric power company in Japan. That sounds like a great investment? Yes?

Student: They own the power plant has been affected by the earthquake in Japan.

Professor Robert Shiller: That’s right. They own particularly the Fukushima power plant. So, I checked out this morning, what the share price is going for in TEPCO. So it was, as of a month or so ago, $25 a share. And it’s down to $5 a share. It just went [SOUND EFFECT INDICATING DOWNWARD MOVEMENT], and you know exactly why. So, I looked at this further. J.P. Morgan estimates now, that claims against TEPCO will be $25 billion, or a couple of trillion yen. But that’s not all. They’re also damaged, right? Everything’s in ruins. So, some people are predicting that TEPCO will go bankrupt, all right?

So, they’ve created this whole mess in Japan, and they’re just going to go bankrupt, and we have limited liability, all right? They’re not going to come after you, all right? The Japanese government could do diligence and find out that you own shares in TEPCO, and TEPCO was negligent, right? They messed up. They didn’t do their safety procedures well enough. But they’ll never go after you. This is the whole idea of limited liability. So many people all over the world are owning shares, and we can’t expect them to be responsible for–you can’t inspect the Fukushima plant, even though you may be a beneficiary of its profits.

So, that’s why they collect the corporate profits–Japan is collecting 40% percent corporate profits tax, and that can be used to offset the damages that the Japanese government now has to pay for. So, it all seems right. There’s a plan here. So, you wonder, is TEPCO private or not? Well, it is private in the sense that there are shareholders and there are profits, but it’s regulated by Japan, it’s taxed by Japan, and Japan pays for their mistakes. So, that’s typical.

I’ll give you another example from this country, General Motors, OK? General Motors was the biggest car company in the United States, and then, it had a little problem during the financial crisis and had to file for Chapter 11 bankruptcy.

What am I referring to, when I say Chapter 11? The Bankruptcy Act has chapters, and each chapter says something different. The two most important chapter for companies are Chapter 7 and Chapter 11, OK? What the bankruptcy law does is, it creates a framework for dealing with insolvency. And the framework says that a company that is in trouble can choose to apply for bankruptcy, and there’s basically two important ways to do that. Chapter 7 details one way you can apply for bankruptcy, and Chapter 11 details another way.

Chapter 7 is liquidation. That means that the company is in such trouble, that we’re going to shut it down and sell off all the assets. Chapter 11 is for a company that is in trouble, but there’s something worth salvaging in terms of operating, continuing the business.

So, GM chose Chapter 11 bankruptcy. They thought, obviously we’ve been making cars for now close to 100 years–well, at least the companies that went together to form GM–and we have a big future. So, we can’t pay our bills now, but we should continue. So, they filed for Chapter 11 bankruptcy. But they were in such trouble, that they couldn’t get out of it, so the U.S. government and the Canadian government invested in GM.

What happened was, General Motors–they changed the name in the most subtle way. The official name of the company was General Motors Corporation, OK? When they filed for Chapter 11 bankruptcy, the shareholders were wiped out–nobody got executed–you lost all your money. And so, if you find in your attic some nice, beautiful share certificates for General Motors Corporation, you can just use them as wallpaper or whatever. They’re worthless. But if it’s different, if it says General Motors Company, because that refers to the new GM–they wanted to change the name, but they didn’t really want to change the name. They had to change the name, so that people wouldn’t confuse the two.

So, what happened? How did we get a new GM? Well, the new GM was owned by the U.S. government. It was equal to–where is it, I had it here–60.8% U.S., Canada owned 12%. The UAW, United Auto Workers, got 17.5%. Why did the union, by the way, get 17% of GM? Well, I don’t know the whole story, but I’m sure it has something to do with GM’s obligations. Maybe they failed on something, I don’t know the details. But it seemed, in the bankruptcy proceedings, that the implicit debts, that the company owed to their workers, would be represented by a share in the company. And then, the rest went to the bondholders, people who own debt, not equity, who own debt in GM, got the remaining share, and they also got warrants, which are options to buy more shares, which will dilute down the U.S. and Canada and UAW shares. So, that’s the settlement.

The result of the settlement was that, it was a government owned organization. Now, they’ve just done an IPO, so they’re reversing this ownership structure. But the point is, that companies that look private may end up government eventually, one time or another. So, companies have to kind of think of themselves as, even in an arch-capitalist country like the United States, as partly government organizations.

By the way, there’s something else called personal bankruptcy. And personal bankruptcy is another involvement of the government in risk management. You as an individual can declare bankruptcy, and you can choose these chapters or you can do–there’s other provisions as well. But you can use Chapter 7 to wipe out all of your debts. The new bankruptcy law that Congress passed a few years ago tends to limit your ability to do that. But within limits, the same government is kind of a shareholder, just as individuals are. I mean, a shareholder in individuals’ lifetime incomes.

Chapter 4. Social Entrepreneurship and Distinguishing between Nonprofits and For-Profits [00:32:26]

I guess, what I’m saying is, that the whole idea of public versus private is a complicated one. And what seems public at one time will seem private at another.

The behavior of nonprofits is not strikingly different than the behavior of for-profits. So, I found a statistic, that 42% of nonprofits pay bonuses to their executives. That is, they’re using the same kind of incentive plans that private corporations do. Why would they do that? Well, they do that because they have to hire people, and people in the for-profit sector are getting bonuses. So, how do you hire someone, and get someone good, unless you pay the bonus as well?

The government faces a big problem, in that the public is very sensitive to paying high salaries to government employees, because they think it’s unfair. Why should some government bureaucrat be paid more than I get? As a result, they have trouble hiring good people. But in the nonprofit sector, the nonprofit sector is not constrained–well, they have some constraints over–they’re regulated to prevent them from stealing the money.

I think, part of the idea of having nonprofits–this is a general point–is, that the government is kind of confined to politically correct, conventional wisdom type activities. And they can do things that are just generally acknowledged by the average person as a good thing, but they can’t do something innovative as well or controversial as well. And I think, that it’s often in those controversial things, that some of our biggest progress is made.

So, I gave the example of Charles Darwin and his professor, who advocated his voyage around the world. Professor–I’m trying to see what his name was, Henslow, I think it was, was actually a–John Stevens Henslow, a botanist but also a advocate of natural theology. And he sent Darwin out on this voyage, because he thought, that studying nature enabled you to discover God. Little did he know, Darwin would end up an atheist after his voyage. But it’s this kind of weird stuff that gets financed. Or Wendy Kopp, I gave as another example, whose ideas were too controversial. I mean, the idea of sending someone out, who didn’t have an education diploma to teach, too controversial.

So, I think that there is maybe a growing recognition of the importance of having people who are–well, there’s a term–social entrepreneurs. I don’t know, whether they’re for-profit or nonprofit, but they’re people who do things out of a sense of mission, beyond making money, but helping the world. And you see this reported in newspapers and magazines, that the 21st century seems to be a century, where there’s more and more of this kind of thing. And it’s in substantial measure, I think, nonprofit.

Chapter 5. Municipal, State and Local Finance [00:36:43]

Now, I wanted to move to the third thing, which I said is municipal, or state and local finance. It’s a big topic, but an awful lot of what gets done in this country is done by state and local governments. It’s something on the order–it’s bigger than the federal government. The state and local governments spend about twice as much money as the U.S. federal government. They run all the public schools, fire departments, police departments, most of the parks. What else? I mean, a lot of things are being run by state and local governments.

I think, another thing that one could do to make things happen in the world–I mentioned the possibility of setting up a nonprofit. You can make things happen by doing that, but you can also make things happen by approaching a local government and saying to them, I think that you would do well to build a hospital, or build a bridge, or build a new school, or even kind of business-oriented things, that would be projects that the government can undertake. And then, they can finance it as a state and local government.

Now one thing, in the United States, every state in the United States has a balanced budget rule. That is, they have to tax people for all of the expenditures they make. They are not allowed to go into debt. But we have to be careful about what the balanced budget rules in their constitution say, because, obviously, there is municipal debt. Governments do borrow money.

State and local governments in the United States have typically–it differs across state–they typically have two budgets. They have an operating budget and a capital budget. The operating budget is what has to be balanced, according to their constitutions. The operating budget involves a list of all the expenditures they made for operations, and the taxes. And they cannot–it differs by state on how it’s worded–but they cannot plan to run a deficit in some states. Or if they do run a deficit on the operating budget, they have to correct it soon or have a plan for correcting it soon.

But the capital budget is different. If a city builds a new school, for example, that’s not an operating expense, right? It’s a capital expense. So, it’s building something that will last through the ages, and so it goes on the capital budget, and not on the operating budget. And all the states allow this. They can raise money by borrowing, and they routinely do that. So, that means they get into debt, and then they have a potential for going bankrupt as well.

So, this is the way it works. Imagine that you’re setting up a new town, and it’s small right now, right? Little town, but we know, that people are coming this way, and it’s going to be a big town in 20, 30 years. So, what do we do? Well, you lay out the streets, and you plan for a big town right now. You better plan for it or it’ll get congested. So, better lay out wide enough streets. That’s easy to do. But you want to build the streets, before the people come, have the layout, and have lots, and have it all planned.

And how about a sewage system? The people aren’t here yet. So, you consult a sewage engineer, and the engineer tells you, you know, if you’re going to build a sewage system, you should do it all at once. It’s going to be too expensive to do it year after year, just adding a little bit, a little bit. You’ve got to have a plan, have an idea, where this city is going. Let’s build it for a city of 20,000 people. We can do it now, but it will cost you $100 million.

So, what do you do? You might say, we can’t pay for that. There’s only 30 people living in this town. How do we come up with 100 million? Obviously, you borrow, right? You put it on the capital budget. And that is fair and just, because then, as people come to the city, they will then pay taxes and pay back the debt. This is the way it works, and it’s the way it’s always worked.

Now, you could say, well, no, it shouldn’t be this way. Why don’t we have all of the individual people pay for their own sewers, and add to the sewer system as they build their houses. It’s not going to work, right? That would be crazy. You’ve got to build the whole system in advance, and so that’s what city governments do routinely. And they go deeply into debt as a result of having created all of these capital investments, and having the debt against them.

So, your city that has 20 people has borrowed $100 million, and it’s going to be a city of 20,000 people, you think. What if it doesn’t work? What if they don’t come? Your plan was wrong. Then, the city is at risk of going bankrupt, right?

So, there’s another whole chapter for municipal bankruptcy, Chapter 9 of the Bankruptcy Code. And Chapter 9 is for city government. There’s a problem, that cities going bankrupt are different, because they don’t have any shareholders, right? They do have an ability to tax people. There’s a question of how much you should tax people in a bankrupt city. If you get tax them too much, they’ll just all leave. So, it’s a subtle problem.

But fortunately, there haven’t been, and I’m not sure we really understand why, there have not been many municipal bankruptcies at all. Between 1975–OK, I’m sorry. Do I have data? I thought I had data on numbers of bankruptcy There are some famous municipal bankruptcies. New York City went bankrupt, or it was about to declare bankruptcy in the 1970s, but it was saved by bailouts. Maybe, that’s the reason why we don’t. Basically, when New York City said, that it couldn’t pay its debts, the State of New York came by with a bailout. And then also, although reluctantly and with a lag, the U.S. federal government came in with a bailout. So, New York never declared bankruptcy.

A lot of cities will have what’s called a ”rainy day fund.” So, they will accumulate assets to help them over troubled times. So, you can collect somewhat higher taxes, and then, you have an endowment, the city has an endowment, which can help tide them over through difficult times. But recently, most of the rainy day funds have been exhausted. The state and local governments saved for a rainy day, and this was a rainy day, this financial crisis. And so, most state and local governments are in trouble right now, because of the recession causing their tax revenues to decline, and there’s increasing worry about municipal bankruptcies. So, I said that there haven’t been many historically, but people are edgy now thinking that there could be some now because of the financial crisis. And so, the yields on municipal bonds have gone up.

Chapter 6. Tax-Exemption of Municipal Bonds [00:46:06]

Municipal bonds are tax-free in the United States. [clarification: Predominantly, municipal bonds are tax-free in the U.S., but there are a few exceptions, as outlined in the Fabozzi et al. textbook.] So, if the City of New Haven issues debt, and you buy the debt, you are not subject to federal income tax on the interest that you earn. That’s because in the constitution it says, that there’s a separation between federal and state. The federal cannot tax the state, so they don’t tax your municipal bond. There’s a subsidy toward municipal bonds implicit in the tax law.

By the way, let me just mention the fact that municipal bonds issued by local governments are not subject to taxes, extends, as well, to Yale University. So, Yale University issues bonds, that are in the same category as municipal bonds, and they’re not taxed. So, there’s an advantage, a tax advantage, and especially higher-income investors like to invest in municipal bonds, because it matters more for higher income investors, because the tax rate hits them more, so there’s an advantage. So, Yale issues municipal bonds, and Yale is an important debtor.

Now, you might wonder about that. So, let’s talk about Yale as a municipal bond issuer. Yale has an endowment of 16 billion as of last year [addition: 2010], and it has a debt of 2.5 billion. So, that leaves Yale with only 13.5 billion in assets after debt. So, you might say, why does Yale borrow money? Right? I mean, it’s got 16 billion in investing. Why is it borrowing? Well, there are many reasons, I suppose, but the immediate and obvious reason that comes to mind is that Yale borrows money, because it can borrow at a tax-subsidized rate, right? If Yale’s debt is not subject to income tax, then that means it can borrow at a lower rate, and Yale would be inclined–or any nonprofit that can issue non-taxable debt–would like to do that, in order to invest in assets that are taxable. Yale doesn’t pay any taxes on either of them.

So, you see what I’m saying? Municipal debt has a lower yield in the market, because everybody knows, it’s not subject to income taxes, so it has a low yield. So, Yale could issue that debt, and use the money to invest in high yielding things that are taxable, and it’s not going to pay taxes on them, either. So, there’s an arbitrage game that Yale could play, or any nonprofit could play, but it does not, because it’s not allowed to, unless it’s using the proceeds of the debt for appropriate causes.

You have to understand, this is why Yale University has a substantial debt, and why the City of New Haven has a substantial debt. It all makes sense in some basic finance framework.

But there’s a lot of concern about indebtedness right now, because, with the financial crisis, the U.S. and Europe and many other countries are suffering debt crises right now. So, it’s renewing calls for a balanced budget amendment. The U.S. government does not have a balanced budget amendment, like the state governments do. And in fact, the U.S. government has only one budget. It does not have a capital budget. So in some sense, the state governments are more sophisticated than the federal government in the U.S., in that they have the distinction between operating and capital budgets.

I guess the reason why the U.S.–the U.S. government has considered adopting a capital budget, but it has never done so. I think, maybe, it’s because the U.S. government has fewer investments, like schools or parks or water facilities, sewage facilities. It doesn’t do that kind of thing, so it doesn’t have as many clearly capital projects. It has a much bigger debt than the state and local governments.

Chapter 7. Government Social Insurance – From Progressive Taxes to Old Age, Survivors, and Disability Insurance (OASDI) [00:51:24]

I guess, then, I’ll move to my last topic today, which is about government social insurance. And this is along the same theme, I’m talking today about the roles of–finance is about risk management, and it’s about incentivization. And some of the basic rules are classified under the rubric of social insurance, which is offered by the government. This is a huge topic.

Social insurance refers to insurance that is not available by a private insurance company, but that is offered generally by governments, and let me just give some examples.

I put it first, progressive taxes. Progressive taxes are income taxes that tax higher income people at a lower rate [correction: at a higher rate]. And progressive taxes have increasingly, in recent years, adopted something analogous to the earned income tax credit, the EITC–that’s the U.S. name for it, but it’s now in many countries around the world–that provides negative taxes for the lowest income people. So, the effect of progressive taxes with earned income tax credit is to insulate people somewhat from shocks to their income.

They call it an earned income tax credit, by the way, because you have to have earned income to get the credit. You can’t be just unemployed. But if you are working and earning very little, especially if you have a family, then you have a negative income tax rate, so that the government augments your low income with a negative tax. I think this is very important, and it actually is effective. Otherwise, the world would be much more unequal than it is now.

I would add, by the way, public services, which are offered out of taxes, to everyone in a country, notably education. School systems are generally free and that is, again, something that–I consider these a form of insurance, because they benefit people, who are unsuccessful in earning money. So, it’s like an insurance program against possible failure in achieving status in the economic system.

So, we also have–I’ll go up here–three, Social Security. And I’m using U.S. terms, but these are terms that–these things happen in virtually all advanced countries. In the U.S., we call it OASDI. That stands for Old Age, Survivors, and Disability Insurance. Old age insurance is pensions, and that’s the biggest part of the social security system in the United States. It’s insuring–well, it’s really something you know is going to happen–you’re going to get old someday, but we call it insurance.

Survivors insurance is life insurance. I mean, it benefits you. You’re getting too old for this now, but if your parents die when you’re young, the U.S. government will give you an income. You’re an orphan, you have nothing, your parents died, and left you nothing, you get survivors insurance. You didn’t know you had this, right? It’s not publicized a lot, but it’s part of what protects people, and it’s offered by the government.

And then thirdly, disability insurance–again, offered by the government–is against you breaking your neck and becoming paralyzed, OK? Or anything like that, that makes it impossible for you to work. The U.S. government will give you an income for life. So, if you are permanently paralyzed, you get an income for life.

All three of these are purchasable in the private sector. You can buy a pension. You can buy survivors insurance–they don’t call it that, they call it life insurance. Just turning it around to a different name. The sellers of life insurance don’t want to remind you that you already have a life insurance policy from the government, because you might say, well, I got enough already. So, they give it a different name and they probably won’t remind you that you have it. And then, you can buy disability insurance.

But part of the problem with private offering of these insurances–disability insurance, if it’s offered privately, suffers a selection bias problem, that some people, who realize that they are going to have a disability, will buy the insurance right away.

And then, we have health insurance. And I don’t want to use the U.S. as an example for this, because we’re kind of a laggard on most of these things. But we had a new health bill that passed under Obama last year, and it’s starting to gear up, but the U.S. is not the world leader in health insurance. It has currently about 40 million people with no health insurance.

And then, there’s workers’ compensation. These are the main aspects of social insurance today. Workers’ compensation is an older form of health insurance that preceded health insurance, at least in the United States. And it compensated workers for accidents that occurred at work, and, in the U.S., this came in in the progressive era. But all these are risk management devices that are offered by governments.

Now, these social insurance schemes are relatively recent innovations, and, in fact, I think, that the first national–I know that–the first national social insurance programs began in Germany in the late 19th century. So, another theme of this course has been that the ability to do things like this requires a developed society with a certain technology, with an information technology, with a bureaucratic technology. And they haven’t been around for that long. If you go back in history 200, 300 or more years, there wasn’t social insurance anywhere. Maybe there was, in some isolated community, but basically it didn’t exist. And so, the history of social insurance is interesting, and I think, it reflects information technology growth.

Chapter 8. The Invention of Social Insurance in Germany [01:00:10]

The country that is most remarkable for having invented social insurance is Germany under Otto von Bismarck in the 1880s. And I think, that it happened there first because of the information technology.

It’s an interesting story that–there were various attempts to start social insurance in different parts of the world, that were half-hearted and failed. In the United Kingdom in the late 1700s, there was a town called Speenhamland, a tiny town in U.K., that decided they would start social insurance. They decided, that there was a living wage that anyone ought to be able to earn, and anyone, who earned less than that, would have the difference paid by the town. So, it’s called the Speenhamland Law, and that town offered to pay the difference. The problem was, it didn’t work. Too many people reported, that they were getting less income than the living income that they defined, and the town discovered it was being ripped off. The problem is they couldn’t identify what a person’s income really was, accurately. They couldn’t tell whether someone was goofing off or not, and so, they dropped it.

I think, there are other examples of failed experiments like this, but it took hold first in Germany in the 1880s, and they got accident insurance, health insurance, and old age insurance, or retirement, for everyone in Germany in the 1880s, and it was considered a fiasco by other countries of the world. When Germany announced these plans to create social insurance, the London Times wrote an article saying, this whole thing will fall through and fail. The government is going to run all of these insurance policies for something like, I think, there were 11 million workers in Germany at the time, and in London they said, you’ve got to be kidding. No government in the world has ever managed to run something like this.

Let’s think particularly about retirement insurance. The German government set up a plan, whereby people would contribute over their working lives to a social security system, and the system would then years later, 30, 40 years later, keep a tab, about how much they’ve contributed, and then pay them a pension for the rest of their lives. So, the Times wondered aloud, are they going to mess this up? They’ve got to keep records for 40 years. They were talking about the government keeping records, and they thought, nobody can really manage to do this, and that it will collapse in ruin. But it didn’t. The Germans managed to do this in the 1880s for the first time, and actually it was an idea that was copied all over the world.

So, why is it that Germany was able to do something like this in the 1880s, when it was not doable anywhere else? It had never been done until that time. I think this has to do ultimately with technology. Technology, particularly information technology, was advancing rapidly in the 19th century. Not as rapidly as in the 20th, but rapidly advancing.

So, what happened in Europe that made it possible to institute these radical new ideas? I just give a list of some things.

Paper. This is information technology, but you don’t think–in the 18th century, paper, ordinary paper was very expensive, because it was made from cloth in those days. They didn’t know how to make paper from wood, and it had to be hand-made. As a result, if you bought a newspaper in, say, 1790, it would be just one page, and it would be printed on the smallest print, because it was just so expensive. It would cost you like $20 in today’s prices to buy one newspaper. Then, they invented the paper machine that made it mechanically, and they made it out of wood pulp, and suddenly the cost of paper went down.

By the way, I found an old textbook from Yale University from 1837. It’s still sitting there on the shelf in the library. I was looking–we were using a Principles of Economics textbook for all Yale students, they all had to take the same course. And there’s a nice little book, but it was so small–I picked it up–it was like that big. You could put in your pocket. I think it’s because books were just expensive, so the students–you have these huge textbooks now, that weigh so much they probably challenge your back–back then, you could carry your books. There was a fundamental economic difference, and so, paper was one of the things.

And you never got a receipt for anything, when you bought something. You go to the store and buy something, you think you get a receipt? Absolutely not, because it’s too–well, they wouldn’t know why, but that’s the ultimate reason–too expensive. And so, they invented paper.

Two, carbon paper. Do you people even know what this is? Anyone here heard of carbon paper? Maybe, I don’t know. It used to be, that, when you wanted to make a copy of something, you didn’t have any copying machines. You would buy this special paper, which was–do you know what–do I have to explain this to you? You know what carbon paper is? You put it between two sheets of paper, and you write on the upper one, and it comes through on the lower one. This was never invented until the 19th century. Nobody had carbon paper. You couldn’t make copies of anything. There was no way to make a copy. They hadn’t invented photography, yet. They had no way to make a copy. You had to just hand-copy everything. The first copying machine–maybe I mentioned that–didn’t come until the 20th century, and they were photographic.

And the typewriter. That was invented in the 1870s. Now, it may seem like a small thing, but it was a very important thing, because you could make accurate documents, and they were not subject to misinterpretation because of sloppy handwriting–and I’m doing sloppy handwriting here for you, but I’m using the old technology here. But the typewriter. And you could also make many copies. You could make six copies at once with carbon paper. And they’re all exactly the same. You can file each one in a different filing cabinet.

Four, standardized forms. These were forms that had fill-in-the-blank with a typewriter.

They had filing cabinets.

And finally, bureaucracy developed. They had management school. Particularly in Germany, it was famous for its management schools and its business schools.

Oh, I should add, also, postal service. If you wanted to mail a letter in 1790, you’d have trouble, and it would cost you a lot. Most people in 1790 got maybe one letter a year, or two letters a year. That was it. But in the 19th century, they started setting up post offices all over the world, and the Germans were particularly good at this kind of bureaucratic thing. So, there were post offices in every town, and the social security system operated through the post offices. Because once you have post offices in every town, you would go to make your payments on social security at the post office, and they would give you stamps, and you’d paste them on a card, and that’s how you could show that you had paid.

So, I think that this kind of information technology brought us the social security system. And the kinds of advances in information technology that we’ve seen more recently will eventually lead to changes in the system. Ultimately, technology drives finance, and the system responds to changes in technology.

Chapter 9. Review of the Social Purpose of Finance and of Behavioral Finance [01:10:20]

All right. So, I just wanted to just wrap up. I talked today about a broader social purpose that’s served by our finance, and it takes place in terms of for-profit as well as nonprofit. But the distinction between for-profit and nonprofit is a subtle one. I think, what happens is, people think of a purpose of something they want to achieve, and then they think, how can I use our financial technology to incentivize people to subscribe capital to this project or to give their personal attention to this project? And then, our system of finance has a lot of things, a lot of devices, that can allow the providence of capital, and that will incentivize people.

I think, another theme of this course has been Behavioral Finance that I think–people are psychological, they have emotions, and they react in complicated ways. One of the oldest themes of economics is that people respond to incentives, but they respond to pleas to their morality as well, or their ideals as well. When we talk about the nonprofit sector, it seems that the financial arrangements reflect a combination of selfish money-oriented incentives and more social-purpose-incentives. And the same thing goes with government activities.

Anyway, I guess, I have one more lecture, and I’m going to talk next time more broadly about, what finance offers us, and how it allows us to achieve social purposes.

[end of transcript]

Back to Top