Yale economist and Nobel Prize Laureate Robert J. Shiller explains why competition in itself does not always weed out deception and rent-seeking.

DAVOS/SWITZERLAND, 28JAN12 - Robert J. Shiller, Arthur M. Okun Professor of Economics, Yale University, USA is captured during the session 'Pundits, Professors and their Predictions' at the Annual Meeting 2012 of the World Economic Forum at the congress centre in Davos, Switzerland, January 28, 2012. Copyright by World Economic Forum swiss-image.ch/Photo by Moritz Hager
DAVOS/SWITZERLAND, 28JAN12 – Robert J. Shiller, Arthur M. Okun Professor of Economics, Yale University, USA is captured during the session ‘Pundits, Professors and their Predictions’ at the Annual Meeting 2012 of the World Economic Forum at the congress centre in Davos, Switzerland, January 28, 2012.
Copyright by World Economic Forum
swiss-image.ch/Photo by Moritz Hager

“Our free-market system tends to spawn manipulation and deception,” proclaim George Akerlof and Robert Shiller in the beginning of their 2015 book, Phishing for Phools: The Economics of Manipulation and Deception (Princeton University Press). It’s not the kind of pronouncement one expects from two Nobel Laureates and staunch free-market advocates like Shiller and Akerlof, but Phishing for Phools is rife with anecdotes that show how firms—from credit card companies to food companies and pharmaceuticals—manipulate customers by taking advantage of their “psychological or informational weaknesses.”

In Internet parlance, “phishing” means an attempt to extract sensitive personal information by masquerading as a reputable or otherwise trustworthy person, company, or website. But Shiller and Akerlof create a broader definition of phishing, using it as a synonym for the mechanisms of manipulation and trickery that, according to them, are inherent to the free-market system. A “phool,” they explain, is anyone who falls for such tricks—that is, everyone, including themselves.

Akerlof and Shiller define themselves as “admirers of the free-market system.” However, they claim that competitive markets are not only the best conduit of providing consumers with the things they want. “They also create an economic equilibrium that is highly suitable for economic enterprises that manipulate or distort our judgment, using business practices that are analogous to biological cancers that make their home in the normal equilibrium of the human body.”

Akerlof and Shiller call this a “phishing equilibrium.” In such an equilibrium, they explain, companies are incentivized to act in a “less than scrupulous” manner. “If we have some weakness or other—some way in which we can be phished for phools for more than the usual profit—someone will take advantage of it,” they write.

Contrary to standard economic thinking, it seems competition doesn’t eliminate this kind of trickery. On the contrary, says Shiller in a phone conversation with ProMarket, it exacerbates it. “It’s especially onerous in tight markets situations, where profit margins are narrow because there’s a lot of competition,” says Shiller. “You as a business cannot not do these tricks, because your profit margin is too narrow. You don’t have the leeway to experiment with not doing it, you’ll go out of business.”

Shiller, the Sterling Professor of Economics at Yale University, is perhaps best known to the general public as the economist who predicted the dot-com crash in his book Irrational Exuberance (Princeton University Press, 2000) and then predicted the burst of the American housing bubble in the book’s second edition. He is also known as the co-creator of the S&P/Case-Shiller Home Price Indices, the leading index measuring U.S. home prices, which he originally developed in the 1980s with Wellesley College economist Karl E. Case.

In 2013, Shiller shared the Nobel Prize in Economics with University of Chicago economists Eugene Fama and Lars Peter Hansen for his pioneering research into the irrationality of financial markets. In 1981, Shiller published the landmark paper “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” in which he compared movements in stock prices with subsequent dividends and found that prices were much more volatile than they should have been had investors and markets operated in a strictly rational manner. The paper, which challenged the then-dominant belief in the efficiency of markets, is considered one of the most influential economic papers of the 20th century, and a milestone in the development of behavioral finance.

In a phone interview with ProMarket, Shiller discussed his recent examination of attitudes toward free markets in Russia and the U.S., explained why competition makes phishing worse, and advocated for a Hippocratic oath for financial advisers.

Q: In a recent paper with Maxim Boycko, you conducted a survey examining public attitudes toward free markets and democracy in Moscow and New York and then compared the results with an identical survey you conducted in 1990. There are a number of differences between the results of the 2015 survey and the one from 1990, but the bottom line remained the same: there were only small differences in attitudes toward free markets in the U.S. and Russia. Given that both countries had very different political and economic trajectories, how do you explain the similarities?

Trajectories are different from personal opinions. I think Vladimir Putin is an example of someone managing a strategy at work, keeping control of the propaganda machine, running an authoritarian government. But I don’t think that the extremes that you appear to see are deeply set.

Q: In the survey, you ask this question: “On a holiday, when there is a great demand for flowers, their prices usually go up. Is it fair for flowers sellers to raise their prices like this?” While in both countries most respondents were opposed to this practice, believing it to be unfair, in New York people were much more tolerant of price hikes than they were in 1990 and more accepting of price hikes than in Moscow. Did the definition of what’s unfair in the market change over the last 25 years?


The Americans changed. It’s disconcerting, what you say. There’s more of a regulatory impulse in the U.S. now. There’s the Bernie Sanders effect, after the financial crisis. We had another question about a factory that produces kitchen tables, and we asked is it fair for them to
raise prices if demand goes up, and there was substantial change in the U.S. between 1990 and 2015. The basic similarity between the U.S. and Russia was the most striking thing here. We had another question: “Apart from fairness, should the factory have the right to raise the price in this situation?” And here, the percent of New Yorkers who think they should have the right went down. It’s a little difficult to understand these results.

Q: Is it possible that this increase in tolerance toward price hikes in the U.S. is an Uber effect?

That’s interesting. We didn’t ask directly about that, but I can easily imagine that a lot of people are impressed with Uber. It’s so modern a system, always available, maybe at a higher price. It would be plausible to me that people are more tolerant of peak growth pricing. We didn’t ask about it, but I can imagine. On the other hand, there are many people who are angered by Uber.

Q: You mentioned the Bernie Sanders effect. In this presidential election, there are candidates from both parties that say the system is rigged, that the free market has been distorted by special interests. Americans believe in free markets,but is it possible that they perceive the free-market system in its current state as less than free?

I don’t have questions that directly relate to this, but maybe there’s more perception of monkeying with markets behind the scenes, like bribing lawmakers or influencing lawmakers to support monopolies. It seems plausible to me that people are more aware of that than they were 20 years ago.

Q: There’s extensive literature that shows that when firms seek rents instead of investing in improving services and products, consumers pay higher prices. In Phishing for Phools, you raise a new idea: not only do companies “phish for phools,” but they invest more and more resources in manipulating and “phooling” their customers. For many years, economists thought the solution to rent-seeking was competition, that competition will weed out rent-seeking firms. Many of the industries you survey in the book operate in competitive markets, but the competition seems to be not who can create better products or services, but who can better “phish for phools.”

That’s well put. [In the book] we emphasize a “phishing equilibrium.” It’s especially onerous in tight markets situations, where profit margins are narrow because there’s a lot of competition. You as a business cannot not do these tricks, because your profit margin is too narrow. You don’t have the leeway to experiment with not doing it; you’ll go out of business. So it’s fear that causes business owners to do that, or a sense of responsibility to their investors, or even their employees. It’s just reality that is imposed on them, that they have to engage in state-of-the-art phishes.

Q: The existence of a phishing equilibrium suggests that competition alone is not weeding out the rents, or eliminating phishing?

It’s making it stronger.

Q: Yet regulators today have really just one tool: competition. If competition doesn’t work, if it in fact, as you say, exacerbates the situation, what other tools are there?

It’s both government regulation and business sector organizations like chambers of commerce or better business bureaus, or consumer advice magazines. We’re seeing some progress with the Internet. A lot of retail is done online, and it shows comments by these buyers—that’s a new development. It’s also capable of being manipulated, so there need to be some standards.

Q: We’re used to think that you can only phish, or charge rents, if you have political connections. But in the book you show that firms can do that for many years without being politically connected, which means phishing is not just the result of cronyism, but inherent to the market system. Is it possible to mitigate this phenomena by making people more aware of phishing, through the media, academia, even crowd-sourced review services like Yelp? 

The problem is all these people have incentives of their own. You mentioned the media—the media are phishing as well.

Ultimately, part of what preserves it is that normal people don’t think of themselves as crooks. They want their work to make them wealthy but also make them feel good and beneficial. That’s why we have business organizations that advocate for better business standards. Adam Smith wrote The Wealth of Nations, which was an argument for free markets, but he also wrote The Theory of Moral Sentiments, in which he made an observation about human nature that seems inconsistent with his other book. He uses the word “praiseworthiness”: people love praise—it’s part of our human condition, something that evolved in Darwinian evolution to make a better society—but Smith said as people mature, they end up wanting to be praiseworthy. Even if no one is praising them, they still want to think: “I’m a good person, I’m a contributor to society.” This is Adam Smith talking 250 years ago.

I think that’s part of how the free market system works. Even in the 1700s you had an organization called The Guardians, or Society for the Protection of Trade against Swindlers and Sharpers, that accepted consumer complaints and imposed business standards.

Q: In your research and writing, you deal extensively with public trust, and whether the public trusts or doesn’t trust government or markets. What leads to trust, or a lack of trust? Is it outcomes, the service that people get, or is it other players within the idea sphere that influence the public’s perception?

Perception affects the sense of trust. Consider the United States: in the Revolutionary War, the U.S. government issued paper money, the Continental currency, and they ended up inflating it ridiculously until it became worthless. For a long time afterwards, the public wouldn’t trust the government. Until the National Bank Act of 1863, paper money was issued by private banks, local banks. I think this is because this was the perception that you can’t trust the U.S. government, it’ll debase the currency. But I know the local bank in my town, and we know the family, they’re trustworthy.

Then, after that, there were a number of banking crises where these local banks failed and people lost money, and people went back to the government and established the Federal Reserve system, where board members are appointed for 14-year terms and they can’t be removed without impeaching them. So there was still this idea that certain kinds of people are trustworthy. You take a banker, appoint him to the Fed board, you can’t get rid of him for 14 years—and people thought those people can be trusted.

Nobody knows who to trust—that’s the problem. We keep getting let down. 

Q: In
Phishing for Phools, you emphasize the economic importance of stories—stories we tell ourselves, stories told to us by firms—and tie it to the prevalence of phishing. Is the current story we tell ourselves one in which markets have to be regulated, because they inherently include things like phishing?

It’s hard to summarize a prevailing story, because there are so many stories going on. I came out with the third edition of my book Irrational Exuberance last year, and in it I talked about what I thought was the prevailing new normal story that we have now. The “new normal” story, I think, is one about globalization and a lack of loyalty by people in our country who hire desperate poor people and put them in sweatshops to compete with Americans. There’s also fear about automation and robots eliminating jobs, and much talk of inequality.

Talk about inequality creates a sense of insecurity: people don’t know what they’ll be doing in 20 years, will they even have a job. The free market system was supposed to always create new jobs, now you’re seeing more and more doubts raised about that. There might be a shift away from free markets.

The Bernie Sanders phenomenon and the Donald Trump phenomenon are both responding to the same anxieties. The Sanders phenomenon is saying we have to get some justice for everyone through the government. The Trump phenomenon is saying if you do your thing in a businesslike manner, if you trust Trump to create a business environment to “make America great again,” you’ll be alright.

Q: How does the American healthcare system fit in to the Phishing for Phools story? In the book you write: “the purveyors of medicine phish us for phools.” Is Phishing prevalent in American health care?

Seems that way. We spend a lot of money and don’t have the best outcomes.

Q: How can regulators mitigate phishing in health care, given that Kenneth Arrow already showed 50 years ago that there’s a problem with applying competitive market models to health care? 

It’s interesting, because Obamacare is really a system to encourage free-market competition in health care through exchanges, trying to create a more level playing field. The problem is that people find it difficult to make these comparisons.

In the book we talk about the American Medical Association, which over the last century focused on exposing bad practices. The AMA is a nonprofit, and it fostered better intelligence concerning health care. Close to 100 years ago, they had reports about bad practices and products, and that helped alleviate bad medical practices. 

Q: Many of the industries that you survey in the book share three characteristics: their services and products are complicated, so there’s information asymmetry. Also, these are services that are ongoing, like credit cards or insurance. Another shared characteristic is that phishing seems to favor mostly for large firms, that have the reputation, the resources and the economies of scale to engage in it. Is phishing also a size issue?

I haven’t done research on this, but it sounds plausible. Especially when it comes to advertising, maybe less so when we have more targeted advertising. It used to be that you couldn’t target your advertising at all. If you’re just dumping your ads out to the whole nation that is more effective to big companies than for local companies.

Q: Is phishing inherently a part of the free-market? Could you have written this book in 1855?

There was phishing, so you could have written the book back then. Some of our book refers to 1855. Maybe it’s gotten more dramatic with the rise of corporations. Big corporations then were limited in scope. There’s also more professionalism. Marketing was primitive in 1855. There’s technological progress in phishing. People learn from watching others. We also have business schools now. Wharton, the first business school in the United States, was established in 1881.

Q: Are you saying business schools teach students to phish?

They have marketing departments. I think business schools also require business ethics. There’s been a movement over the last couple of decades towards more attention to business ethics. Sometimes I admire marketing departments, because they focus on a certain aspect of business reality. It’s better that we have people who are not trying to make money themselves studying that phenomenon in an academic setting.

Q: Should ethics be taught in business schools? In your opinion, should MBA programs contain an ethical component?

I think business schools offer courses in ethics, but they don’t require them. I think they’re trying to encourage it. The problem is it starts to look preachy if it’s mandatory; people don’t want to be there. But maybe it should still be there.

Q: Could we reduce phishing by having business schools teach MBA students that they have other responsibilities besides maximizing shareholder value?

This is what should happen in business education. Typically, an MBA student has been in the business world for some years. When they’re back to a college environment, they’re free from the constraints of not revealing their company’s secrets. Hopefully people will talk these things out and reach more enlightened decisions about how they will handle morally compromising business situations in the future.

Q: Would something like a Hippocratic oath for business students help promote better business ethics?

This is something that I advocated in my book The New Financial Order: Risk in the 21st Century. I advocated that the government should offer a tax subsidy to financial advisers who sign something like the Hippocratic oath for their customers: “The welfare of my clients is my number one concern.” It has to be worded carefully so it has some teeth.

Q: The Department of Labor’s new “fiduciary rule,” which requires brokers who work with retirement accounts to act in clients’ best interests, seems like a step in that direction.

I didn’t read it carefully, but it sounds like a good thing.

Q: A recent study by Amit Seru and Gregor Matvos from the University of Chicago and the University of Minnesota’s Mark Egan, argued that in the financial advisory industry there are firms whose business model consists of manipulating unsophisticated clients, often the elderly or less educated. You mentioned government subsidies for advisers who agree to take a Hippocratic oath—is that a possible way of mitigating this phenomenon?

That’s one of the ways of making it happen. We have this organization called NAPFA, the National Association of Personal Financial Advisors, that makes its members sign a fiduciary oath. They have been hit with scandals of their own lately. With human nature being what it is, there are always going to be lapses.

Q: So there’s always going to be phishing, and we need to figure out how to live with it?

I think we can improve. We have already done much to improve the situation. I think we need to constantly be aware of new technologies of phishing. If nothing is done about it, this becomes part of the equilibrium.