Correcting poor analysis / Some of the antiurban arguments fail because they do not think in per-capita terms. A map of greenhouse gas emissions in Milwaukee revealed that the central areas were the worst offenders. But, as Meyer points out, that's because it was calculated on emissions per acre, not per household. A map based on the more logical per-household basis shows that the city-dwellers produce the least amount of greenhouse gases. Meyer rightly insists that critics not simply criticize places and the people who live there; he wants to know where those people would live if not in cities and what impact that change would have on both the people and the environment. It's not unlike the economic idea of opportunity cost, exemplified by the jokey repartee, "How's your spouse?" "Compared to what?"

Another common error that Meyer exposes is inappropriate statistical comparison. A United Nations study of the supposed evils of urbanization in the developing world compared the well-being of "slum dwellers"—itself a tendentious term—to all other urban residents and all rural populations. The appropriate comparison, of course, would be some subset of rural populations, since some rural folks are doing just fine while many others are a lot worse off that those who live in "slums."

And so it goes throughout the book. Meyer demolishes statistical and logical fallacies about the comparative evils of water pollution (much safer in cities), natural hazards like tornadoes (easier to spot and shelter in cities), technological hazards like automobile accidents (congestion has its benefits), and infectious diseases. Concerning the last, I was unaware that the Bubonic Plague was considerably worse in rural Europe.

Meyer's next-to-last chapter, "Human Habitat," is actually his best and I would urge readers impatient with his leisurely introductory material to start there. In it, he deals head-on with the argument that cities are just bad for people, inconsistent with human nature and our evolutionary needs. The antiurbanists' most dramatic and persistent story is the "rats study," published in Scientific American in 1962. Common rats were placed in an enclosed space of fixed dimensions, given plenty of food and water, and allowed to breed indefinitely. They eventually became annoyed with their overly close neighbors and developed pathologies that antiurbanists attributed to densely populated human cities. Meyer notes that Lewis Mumford, the famous critic of city bigness, opined that the rats in the study "exhibit the same symptoms of stress, alienation, hostility, sexual perversions [circa 1968], parental incompetence, and rabid violence that we now find in Megalopolis."

The first response by the tribe of economists to these arguments would usually be revealed preference. Billions of people generally do not move to cities unless they expect their lives to be better than in nonurban places. Urbanization is a worldwide phenomenon. With few exceptions, people were not compelled to move from rural to urban areas. Unlike rats in a box, most humans have the option of leaving if they don't like local conditions. Indeed, the most notable compulsory urban policies were undertaken by dictators who forcibly removed people from cities (e.g., Pol Pot's evacuation of Phnom Penh) and by the authoritarian governments of Russia and China, whose internal passport systems keep many citizens from moving to cities in order to better their lives—and perhaps demand better governance.

Interestingly enough, revealed preference is Meyer's first argument, too, even though his tribe is that of geography. The antiurbanists who condemn Megalopolis sound like the supposed saying of Yogi Berra: the place is so crowded that no one goes there anymore. (Meyer actually uses the line.) This is not to say that big cities lack environmental problems, but, as Meyer points out, the close proximity of people in urban areas produces a local political climate that can manage collective problems before they turn into the rat-like disasters that animated Mumford's imagination.

Suburbia / The more problematic aspect of the book is that Meyer cannot decide whether suburbs are a legitimate part of cities. He often alludes to cities as entire metropolitan areas, which would include suburbs. But at other times he sees suburbs as somehow antiurban, something whose growth should be condemned as "sprawl" that chews up the environment. He is dismissive of the work of Robert Bruegmann, whose Sprawl: A Compact History punctured the myths that suburbanization is historically recent, peculiarly American, and bad for cities.

It is fine to be ambivalent about American suburbanization. I have argued that unchecked local zoning and federal tax and expenditure policies have made American cities excessively spread out, causing too much commuting and undermining the benefits of proximity. But even without those policies, it is likely that American metropolitan populations—and those of most other high-income societies—would mostly live in suburbs. Shlomo Angel and colleagues have demonstrated in a remarkable project, The Atlas of Urban Expansion, that almost every city in the world is spreading out spatially while becoming less densely populated.

The reason for worldwide suburbanization is fairly straightforward: Personal incomes are rising in nearly all cities, in large part because urban agglomeration economies make workers more productive. Most people with more disposable income want some additional living space, both indoors and out, and the suburbs are the cheapest place to get it. It is revealed preference all over again.

The hazard of neglecting this benign explanation for suburbanization is that defenders of urbanization don't know where to stop. They seem to think that if some density is good, higher density must always be better. This is the main rationale for urban containment policies such as those in Portland and Seattle, which restrict suburbanization and aggressively promote infill policies. To my mind, metropolitan infill policies are usually helpful insofar as they sweep aside parochial land-use policies that unreasonably limit redevelopment. But if infill projects are good enough to attract residents downtown, there's no reason to forbid suburban development for those who want it, provided developers are willing to pay for the infrastructure costs that accompany it. City life can compete with suburban life without forcing people to choose high-rises and public transit. Perhaps Meyer's next book should address the "commonsense" arguments that see suburbanization as the dysfunctional appendage of urbanization rather than a natural complement of successful city growth.

Conclusion / In the meantime, I hope the present book gets the attention it deserves. I predict it will not, though. Among the famous environmental thinkers that Meyer criticizes are Lester Brown and Paul Ehrlich. Meyer writes, "In 1976, Lester R. Brown predicted that cities could never house a majority of the human population (as in fact they now do) because the world's resource base could not meet what he called 'the additional energy costs of urban living.'" Ehrlich is called out as one of those who erroneously used the Black Death of medieval Europe as a precursor to runaway diseases in modern cities.

Meyer is actually too kind to Brown and Ehrlich. They are so often off base in their predictions of environmental and human catastrophe that one would expect them to be hiding under rocks. To the contrary, both have received "genius" grants from the MacArthur Foundation and both are the recipients of numerous honorary degrees and other public honors. In the field of environmental commentary, it seems, it's a lot more profitable to be furious and fanatical than, like Meyer, sound and sensible.

Perverse Incentives in the Financial World

REVIEW BY DAVID R. HENDERSON

DAVID R. HENDERSON is a research fellow with the Hoover Institution and an associate professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, Calif. He is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008). He blogs at www.econlog.econlib.org.

Advocates of free markets and deregulation are often accused of being apologists for big business. The main reason for this seems to be that we defend the rights and accomplishments of big businesses that achieve great things under economic freedom. But we have always been careful to defend economic freedom, not big business per se. If I were to recommend one book to disabuse people of the idea that being pro-freedom necessarily means being pro-big business, that book would be Jonathan R. Macey's The Death of Corporate Reputation. But that is only one of many things that recommend the book.

Macey, a professor of finance at Yale University, is a long-time observer and analyst of both corporate finance law and actual finance as practiced on Wall Street. He has written profusely on the topics covered in this book. His broad claim is summarized in the title of this book and in the subtitle: How Integrity Has Been Destroyed on Wall Street. Macey is a harsh critic of both government regulators and private financial actors. He argues that government regulation has failed and that perverse regulation, combined with changes in technology and information costs, has reduced the value of reputation in financial markets. He makes his case sector by sector, taking on accounting firms, law firms, credit rating agencies, stock exchanges, and the Securities and Exchange Commission. He sometimes overstates his case. At times, I found his evidence better than his theoretical argument, and one piece of evidence—on the legendary junk-bond king, Michael Milken—actually undercuts his argument. But his big-picture reasoning and conclusions are broadly convincing and his case gets stronger as the book progresses.

Does reputation matter? / Macey begins by pointing out the received economic wisdom on the importance of reputation. Companies have an incentive to establish a reputation for quality and honesty whenever their product is hard for consumers to judge. That works with businesses ranging from the local dry cleaner to the largest auto company. When companies' reputations suffer, the companies suffer. That's what gives them the incentive.

Macey gives the example of Bankers Trust, a financial company that, as its name implies, built its business by earning its customers' trust. But that changed in the 1990s when Bankers Trust took advantage of two of its clients, Gibson Greeting Cards and Procter and Gamble (P&G). Bankers Trust made complex financial derivative deals with those clients, deals that it understood better than the clients did. In the P&G deal, P&G ended up paying interest rates over 14 percentage points above the market. In the discovery process, after P&G sued Bankers Trust, a document was found describing a conversation between two Bankers Trust employees in which one said that P&G would "never be able to know how much money was taken out of that [swap by Bankers Trust]," and her colleague responded, "That's the beauty of Bankers Trust." Although Bankers Trust settled, it ultimately lost in the marketplace because its reputation was damaged.

Fast forward to a 2010 lawsuit that charged Goldman Sachs with behaving unethically. Goldman had claimed in its 2007 annual report that "[o]ur reputation is one of our most important assets" and that "[i]ntegrity and honesty are at the heart of our business." In defending itself, Goldman claimed that no one should have believed those claims because they are simply "puffery"—that is, subjective opinions used in sales and advertising that people are not supposed to take literally. In other words, Goldman Sachs itself was claiming that its own reputation didn't matter. That seems like Macey's smoking gun for his claim that reputation matters much less today than it used to.

The financial stakes in many of today's deals are even higher and so one might think that reputation matters even more. So why does reputation matter so much less? Macey argues that precisely because the stakes are so high, individuals in a firm can cheat a few times and, even if their reputation is damaged as a result, live luxuriously on the interest from their ill-gotten gains. Also, he writes, because the cost of getting information about particular individuals in a firm is so low, individual reputations have become unhinged from firm reputations. That means that individuals in a firm have much less incentive to monitor the behavior of other people in the firm.

Even if he is right that individual reputations matter more and firm reputations matter less, that still means that reputation matters. His account of the 1980s Milken case illustrates that. Macey shows that Milken did great work for his firm's clients, helping companies finance takeovers and expansions using high-yield, or "junk," bonds. But an ambitious prosecutor, Rudy Giuliani, got favorable publicity by going after Milken viciously for minor trading violations. Macey points out that the Milken case shows that "being sued and pleading guilty, even in a criminal case brought by the federal government, was no longer a death blow to one's reputation." Exactly. But that does not mean that reputation doesn't matter. On the contrary, it means that potential clients could see through Giuliani's thuggish behavior and judge Milken on what really mattered: good value and honest dealing.

But surely accountants who audit companies' financial statements must worry about their own reputations and, therefore, have a strong incentive to root out financial misdoings in the companies they audit. Not so, argues Macey. His argument is twofold. First, the move in the accounting industry from general partnerships to limited liability partnerships means that a partner in an accounting firm does not have the same financial stake he used to have in monitoring his colleagues' work. Second, accounting firms often also do lucrative consulting for the firms they audit, setting up an inherent conflict of interest.

What about lawyers? Macey argues that "improved information technology, the passage of the securities laws, and the increase in both in-house counsel and specialization of lawyers' functions have decreased lawyers' incentives to monitor their colleagues and, by extension, their firms." All true. But there are two things to note: First, the securities laws that he discusses were passed in 1933 and 1934, so it's hard to argue that those laws are responsible for any recent decline in the reputation of law firms. Second, as he himself admits, whatever is true about law firms, an individual lawyer's reputation still matters for that lawyer.

Nor, writes Macey, can we depend on credit rating agencies. The reason: regulation. In 1975, the SEC designated only two agencies, Moody's and Standard & Poor's, as "nationally recognized statistical rating organizations" (NRSROs). Later, a third firm, Fitch, was designated as an NRSRO. (A few "boutique" firms have subsequently been named NRSROs, but the original three dominate the market.) It was only a matter of time before the SEC and state and local regulators required that bonds get a seal of approval from one of those three firms before banks, money market funds, pension funds, and other fiduciary organizations could invest in them. That not only created a cozy cartel, but also diminished the incentive of those three firms to care about quality: when someone has to buy your product anyway, there is less incentive to produce a good product. Macey argues that the credit agencies' ratings are virtually worthless. Still, he notes, investors pay attention to them. Why? He attributes it to a "lemming" effect. But wouldn't we expect market players with millions of dollars at risk not to pay attention to worthless information, especially when they have had years to realize how little value the credit rating agencies create? I would have thought that Macey, with his deep understanding of markets, would think so.

Government reputation / One of the most important chapters contains Macey's explanation of the incentives facing SEC employees. I have always wondered why the infamous Bernie Madoff got away with his Ponzi scheme for so many years, despite six warnings to the SEC by knowledgeable people who suspected such a scheme. After reading Macey's masterful chapter on the SEC, I wonder no more. Macey writes, "The SEC has few incentives to investigate the simple but effective sorts of fraud schemes that Bernard Madoff masterminded because there are few career payoffs to doing so." Macey points out that the big, well-known financial firms, where many of the SEC enforcers ultimately want to work, would never engage in Ponzi schemes. So there is no reason for SEC enforcers, from a narrow career viewpoint, to pay attention to such schemes.

Lawyers at the SEC formulate complex regulations that have little to do with protecting the investing public. They will then be expert at helping firms comply with the regulations. Macey does not just speculate about this. He points out three instances in which lawyers at the SEC have gone on to lucrative positions with major Wall Street firms. One former SEC director of enforcement, writes Macey, "is a partner in the giant law firm of Davis, Polk & Wardwell, which represents many clients before the SEC." That person's predecessor at the SEC "is the general counsel at JP Morgan Chase." And this latter's predecessor left the SEC to become general counsel at Deutsche Bank. Unfortunately, neither Macey nor the source he cites on those facts actually names the three people involved. Given that this book is about reputations, including those of individuals, the absence of that important detail is disappointing.

I shouldn't end this review without mentioning the horror story of a firm called Egan-Jones. The firm was a small rating agency that had the effrontery to downgrade the U.S. government's debt in July 2011 from AAA to AA+, well before Moody's and Standard & Poor's downgrade. Within three months, Egan-Jones received notice from the SEC that it would be the target of an SEC legal action. Officially, the action had nothing to do with the downgrade; rather, the firm was charged with failing to meet a technical SEC requirement that ratings of bonds be "disseminated publicly." But Egan-Jones' well-known business model was to charge bond buyers, rather than sellers, for its ratings—a practice that protects the firm from the perverse incentive of issuing ratings to please the sellers. If the company disseminated its information publicly, why would anyone pay? The good news is that, according to Macey, "The SEC's campaign against Egan-Jones harmed the SEC's reputation more than Egan-Jones's reputation." Who says reputation doesn't matter?

Macey ends on what is, at best, a semi-hopeful note. Regulation, he points out, is not a good substitute for reputation, so one important step is to deregulate. He understands, as many people do not, that the 1990s and early 2000s were not the golden era of financial deregulation, but rather a time of fairly heavy regulation. Deregulation, he writes, "will help to reestablish incentives for firms to invest in reputation." Fortunately, with this book, he has done his part in trying to get reputation to play a more important role on Wall Street.