Steven Levitt analyzes crack economics

You'll be happy to know that I'll be talking not about my own tragedy, but other people's tragedy. It's a lot easier to be lighthearted about other people's tragedy than your own, and I want to keep it in the spirit of the conference.

So, if you believe the media accounts, being a drug dealer in the height of the crack cocaine epidemic was a very glamorous life, in the words of Virginia Postrel. There was money, there was drugs, guns, women, you know, you name it -- jewelry, bling-bling -- it had it all.

What I'm going to tell you today is that, in fact, based on 10 years of research, a unique opportunity to go inside a gang -- to see the actual books, the financial records of the gang -- that the answer turns out not to be that being in the gang was a glamorous life. But I think, more realistically, that being in a gang -- selling drugs for a gang -- is perhaps the worst job in all of America. And that's what I'd like to convince you of today.

So there are three things I want to do. First, I want to explain how and why crack cocaine had such a profound influence on inner-city gangs. Secondly, I want to tell you how somebody like me came to be able to see the inner workings of a gang. It's an interesting story, I think. And then third, I want to tell you, in a very superficial way, about some of the things we found when we actually got to look at the financial records -- the books -- of the gang.

So before I do that, just one warning, which is that this presentation has been rated 'R' by the Motion Picture Association of America. It contains adult themes, adult language. Given who is up on the stage, you'll be delighted to know that in fact there'll be no nudity, barring a -- (Laughter) -- unexpected wardrobe malfunctions aside. (Laughter)

So let me start by talking about crack cocaine, and how it transformed the gang. And to do that, you have to actually go back to a time before crack cocaine, in the early '80s, and look at it from the perspective of a gang leader. So being a gang leader in the inner city wasn't such a bad deal in the mid-'80s. In the early '80s, some would say.

Now, you had a lot of power, and you got to beat people up -- you got a lot of prestige, a lot of respect. But there was no money in it, OK? The gang had no way to make money. And you couldn't charge dues to the people in the gang, because the people in the gang didn't have any money. You couldn't really make any money selling marijuana. Marijuana's too cheap, it turns out. You can't get rich selling marijuana. You couldn't sell cocaine. You know, cocaine's a great product -- powdered cocaine -- but you've got to know rich white people. And most of the inner-city gang members didn't know any rich white people -- they couldn't sell to that market. You couldn't really do petty crime, either. It turns out, petty crime's a terrible way to make a living.

So, as a result, as a gang leader, you had, you know, power -- it's a pretty good life -- but the thing was, in the end, you were living at home with your mother. And so it wasn't really a career. It was something that -- it's just there were limits to how powerful and important you could be if you had to live at home with your mother.

Then along comes crack cocaine. And in the words of Malcolm Gladwell, crack cocaine was the extra-chunky version of tomato sauce for the inner city. (Laughter) Because crack cocaine was an unbelievable innovation. I don't have time to talk about it today. But if you think about it, I would say that in the last twenty-five years, of every invention or innovation that's occurred in this country, the biggest one, in terms of impact on the well-being of people who live in the inner city, was crack cocaine. And for the worse -- not for the better, but for the worse. It had a huge impact on life.

So what was it about crack cocaine? It was a brilliant way of getting the brain high. Because you could smoke crack cocaine -- you can't smoke powdered cocaine -- and smoking is a much more efficient mechanism at delivering a high than is snorting it. And it turned out, there was this audience that didn't know it wanted crack cocaine, but, when it came, it really did. And it was a perfect drug. You could sell for -- buy the cocaine that went into it for a dollar, sell it for five dollars. Highly addictive -- the high was very short. So for fifteen minutes, you get this great high. And then, when you come down, all you want to do is get high again.

It created a wonderful market. And for the people who were there running the gang, it was a great way, seemingly, to make a lot of money. At least for the people in the top.

So this is where we enter the picture. Not really me -- I'm really a bit player in all this. My co-author, Sudhir Venkatesh, is the main character. So he was a math major in college who had a good heart, and decided he wanted to get a sociology Ph.D., came to the University of Chicago. Now, the three months before he came to Chicago, he had spent following the Grateful Dead. And, in his own words, he "looked like a freak." He's a South Asian -- very dark-skinned South Asian. Big man, and he had hair, in his words, "down to his ass." Defied all kinds of boundaries: Was he black or white? Was he man or woman? He was really a curious sight to be seen.

So he showed up at the University of Chicago. And the famous sociologist, William Julius Wilson, was doing a book that involved surveying people all across Chicago. And he took one look at Sudhir, who was going to go do some surveys for him, and decided he knew exactly the place to send him -- which was to one of the toughest, most notorious housing projects. And not just in Chicago, but in the entire United States.

So Sudhir -- the suburban boy who had never really been in the inner city -- dutifully took his clipboard and, you know, walked down to this housing project. Gets to the first building. The first building? Well, there's nobody there. But he hears some voices up in the stairwell, so he climbs up the stairwell. And he comes around the corner -- finds a group of young African-American men playing dice.

This is about 1990 -- peak of the crack epidemic. This is a very dangerous job, being in a gang -- you don't like to be surprised. You don't like to be surprised by people who come around the corner. And the mantra was: shoot first; ask questions later. Now, Sudhir was lucky. He was such a freak -- and that clipboard probably saved his life, because they figured no other rival gang member would be coming up to shoot at them with a clipboard. (Laughter)

So his greeting was not particularly warm, but they did say, well, OK -- let's hear your questions on your survey. So, I kid you not, the first question on the survey that he was sent to ask was, "How do you feel about being poor and black in America?" (Laughter) Makes you wonder about academics, OK? (Laughter)

So the choice of answers were: very good, good, bad and very bad. What Sudhir found out is, in fact, that the real answer was the following -- (Laughter) The survey was not, in the end, going to be what got Sudhir off the hook. He was held hostage overnight in the stairwell. There was a lot of gunfire; there were a lot of philosophical discussions he had with the gang members. By morning, the gang leader arrived, checked out Sudhir, decided he was no threat and they let him go home. So Sudhir went home. Took a shower, took a nap.

And you and I, probably, faced with the situation, would think, well, I guess I'm going to write my dissertation on The Grateful Dead. I've been following them for the last three months. (Laughter)

Sudhir, on the other hand, got right back -- walked down to the housing project. Went up to the floor, the second floor, and said: "Hey, guys. I had so much fun hanging out with you last night, I wonder if I could do it again tonight." And that was the beginning of what turned out to be a beautiful relationship that involved Sudhir living in the housing project on and off for 10 years: hanging out in crack houses, going to jail with the gang members, having the car-windows shot out of his car, having the police break into his apartment and steal his computer disks -- you name it. But ultimately, the story has a happy ending for Sudhir, who became one of the most respected sociologists in the country. And especially for me, as I sat in my office with my Excel spreadsheet open, waiting for Sudhir to come and deliver to me the latest load of data that he would get from the gang. It was one of the most unequal co-authoring relationships ever -- (Laughter) -- but I was glad to be the beneficiary of it.

So what do we find? What do we find in the gang? Well, let me say one thing. We really got access to everybody in the gang. We got an inside look at the gang, from the very bottom up to the very top. They trusted Sudhir -- in ways that really no academic has ever -- or really anybody, any outsider -- has ever earned the trust of these gangs, to the point where they actually opened up what was most interesting for me: their books, their financial records that they kept. And they made them available to us. And we not only could study them, but we could ask them questions about what was in them.

So if I have to kind of summarize very quickly in the short time I have what the sort of bottom line of what I take away from the gang is, is that if I had to draw a parallel between the gang and any other organization, it would be that the gang is just like McDonald's. In a lot of different respects -- the restaurant McDonald's.

So first, in one way -- which isn't maybe the most interesting way, but it's a good way to start -- is in the way it's organized -- the hierarchy of the gang, the way it looks. So here's what the org chart of the gang looks like. I don't know if any of you know very much about org charts, but if you were to assign a stripped-down and simplified McDonald's org chart, this is exactly what the org chart would look like. Now, it's amazing, but the top level of the gang, they actually call themselves the "board of directors." (Laughter)

And Sudhir says it's not like these guys had a very sophisticated kind of view of like, what happened in American corporate life. But they had seen movies like "Wall Street," and they kind of had learned a little bit about what it was like to be in the real world. Now, below that board of directors, you've got essentially what are regional VPs -- people who control, say, the south side of Chicago, or the west side of Chicago.

Now, Sudhir got to know very well the guy who had the unfortunate assignment of trying to take the Iowa franchise. (Laughter) Which, it turned out, for this black gang, was not one of the more brilliant financial endeavors that they undertook. (Laughter)

But the thing that really makes the gang seem like McDonald's is its franchisees. That the guys who are running, you know, the local gangs -- the four-square-block by four-square-block areas -- they're just like the guys, in some sense, who are running the McDonald's. They are the entrepreneurs. They get the exclusive property rights to control the drug-selling. They get the name of the gang behind them, for merchandising and marketing. And they're the ones who basically make the profit or lose a profit, depending on how good they are at running the business.

Now, the group I really want you to think about, though, are the ones at the bottom, the foot soldiers. These are the teenagers, typically, who'd be standing out on the street corner, selling the drugs. Extremely dangerous work. And important to note that almost all of the weight, all of the people in this organization are at the bottom. OK, just like McDonald's. So in some sense, the foot soldiers are a lot like the people who are taking your order at McDonald's. And indeed, it's not just by chance that they're like them. In fact, in these neighborhoods, they'd be the same people. So the same kids who are working in the gang were actually -- at the very same time, they would typically be working part-time at a place like McDonald's. Which already, I think, foreshadows the main result that I've talked about, about what a crappy job it was being in the gang. Because obviously, if being in the gang were such a wonderful, lucrative job, why in the world would these guys moonlight at McDonald's?

So what do the wages look like? So you might be surprised. But based on the actual -- you know, being able to talk to them, and to see their records, this is what it looks like in terms of the wages. The hourly wage the foot soldiers were earning was $3.50 in an hour. It was below the minimum wage, OK? And this is well documented. It's easy to see, by the patterns of consumption they have. It really is not fiction -- it's fact. There was very little money in the gang, especially at the bottom.

Now if you managed to rise up -- say, and be that local leader, the guy who's the equivalent of the McDonald's franchisee -- you'd be making 100,000 dollars a year. And that, in some ways, was the best job you could hope to get if you were growing up in one of these neighborhoods as a young black male. If you managed to rise to the very top, 200,000 or 400,000 dollars a year is what you'd hope to make. Truly, you would be a great success story.

And one of the sad parts of this is that indeed, among the many other ramifications of crack cocaine is that the most talented individuals in these communities -- this is what they were striving for. They weren't trying to make it in legitimate ways, because there were no legitimate channels out. This was the best way out. And it actually was the right choice, probably, to try to make it out -- this way. You look at this --

the relationship to McDonald's breaks down here. The money looks about the same. Why is it such a bad job? Well, the reason it's such a bad job is that there's somebody shooting at you a lot of the time. So, with shooting at you, what are the death rates? We found in our gang -- and, admittedly, this was not really sort of a standard situation; this was a time of intense violence -- of a lot of gang wars -- as this gang actually became quite successful. But there were costs. And so the death rate -- not to mention the rate of being arrested, sent to prison, being wounded -- the death rate in our sample was seven percent per person per year. You're in the gang for four years; you expect to die with about a 25 percent likelihood. That is about as high as you can get.

So for comparison's purposes, let's think about some other walk of life where you may expect might be extremely risky. Like let's say that you were a murderer and you were convicted of murder, and you're sent to death row. It turns out, the death rates on death row -- from all causes, including execution -- two percent a year. (Laughter) So it's a lot safer being on death row than it is selling drugs out on the street.

That makes you pause -- gives you some pause -- those of you who believe that a death penalty's going to have an enormous deterrent effect on crime. Now to give you a sense of just how bad the inner city was during crack -- and I'm not really focusing on the negatives, but really, there's another story to tell you there -- if you look at the death rates -- just of random, young black males growing up in the inner city in the United States -- the death rates during crack were about one percent. That's extremely high. And this is violent death -- it's unbelievable, in some sense.

To put it into perspective, if you compare this to the soldiers in Iraq, for instance, right now fighting the war: 0.5 percent. So in some very literal way, the young black men who were growing up in this country were living in a war zone, very much in the sense of the way that the soldiers over in Iraq are fighting in a war.

So why in the world, you might ask, would anybody be willing to stand out on a street corner selling drugs for $3.50 an hour, with a 25 percent chance of dying over the next four years? Why would they do that? And I think there are a couple answers.

I think the first one is that they got fooled by history. It used to be the gang was a rite of passage. That the young people controlled the gang -- that, as you got older, you dropped out of the gang. So what happened was, the people who happened to be in the right place at the right time -- the people who happened to be leading the gang in the mid- to late '80s -- became very, very wealthy. And so the logical thing to think was that: "Well, the next generation -- so they're going to age out of the gang, like everybody else has, and the next generation is going to take over and get the wealth."

So there are striking similarities, I think, to the Internet boom, right? The first set of people in Silicon Valley got very, very rich. And then all of my friends said: "Maybe I should go do that, too." And they were willing to work very cheap, for stock options that never came. In some sense, that's what happened, exactly, to the set of people we were looking at, is that they were willing to start at the bottom. Just like, say, a lawyer at a law firm -- a first-year lawyer is wiling to start at the bottom, work 80-hour weeks for not that much money, because they think they're going to make partner. But what happened was, the rules changed, and they never got to make partner.

Indeed, the same people who were running all of the major gangs in the late 1980s are still running the major gangs in Chicago today. They never passed on any of the wealth. So everybody got stuck at that $3.50-an-hour job, and it turned out to be a disaster.

The other thing the gang was very, very good at was marketing and trickery. And so for instance, one thing the gang would do is -- you know, the gang leaders would have big entourages, and they'd drive fancy cars and have fancy jewelry. So what Sudhir eventually realized, as he hung out with them more, is that, really, they didn't own those cars. They just leased them -- because they couldn't afford to own the fancy cars. And they didn't really have gold jewelry -- they had gold-plated jewelry. It goes back to, you know, the real-real versus the fake-real.

And really, they did all sorts of things to trick the young people into thinking what a great deal the gang was going to be. So for instance, they would give a 14-year-old kid -- they'd give him a whole, you know, roll of bills to hold. That 14-year-old kid would say: "Oh, well ..." You know, he would say to his friends, "Hey, look at all the money I got in the gang." It wasn't his money, until he spent it. And then essentially he was in debt to the gang, and was sort of an indentured servant for a while. So I have a couple minutes.

Let me do one last thing I hadn't thought I'd have time to do, which is to talk about what we learned, more generally, about economics from the study of the gang. So economists tend to talk in technical words. Often, our theories fail quite miserably when we go to the data. But actually, what's kind of interesting is that in this setting it turned out that some of the economic theories that worked not so well in the real economy worked very well in the drug economy -- in some sense because it's unfettered capitalism. Here's an economic principle. This is one of the basic ideas in labor economics, called a "compensating differential." It's the idea that basically, the increment to wages that a worker requires to leave him indifferent between performing two tasks -- one which is more unpleasant than the other -- that's what you call a "compensating differential." It's why we think garbage men might be paid more than people who work in parks, OK?

So in the words of one of the members of the gang I think makes this clear. So it turns out -- I'm sort of getting ahead of myself. It turns out, in the gang, when there's a war going on, that they actually pay the foot soldiers twice as much money. It's exactly this concept. Because they're not willing to be at risk. And the words of a gang member capture it quite nicely. He says, "Would you stand around here when all this shit" -- that means shooting -- "if all this shit's going on? No, right? So if I going to be asked to put my life on the line, then front me the cash, man." So essentially, I think the gang member says it much more articulately than does the economist, about what's going on. (Laughter)

Here's another one. So economists talk about game theory -- that every two-person game has a Nash equilibrium. Here's the translation you get from the gang member. They're talking about the decision of why they don't go shoot -- one thing that turns out to be a great business tactic in the gang, if you go and just shoot in the air -- just shoot guns in the other gang's territory -- all the people are afraid to go buy their drugs there. They're going to come into your neighborhood.

But here's what he says about why they don't do that. He says, "If we start shooting around there," -- in the other gang's territory -- "nobody, and, I mean, you dig it, nobody, going to step on their turf. But we gotta be careful, because they can shoot around here, too, and then we all fucked." (Laughter) So that's exactly the same concept. But then, again, sometimes economists get it wrong. So one thing we observed in the data is that it looked like, in terms of ... The gang leader always got paid, OK? No matter how bad it was economically, he always got himself paid.

So we had some theories related to cash flow, and lack of access to capital markets, and things like that. But then we asked the gang member, "Well, why is it you always get paid, and your workers don't always get paid?" His response is, "You got all these niggers below you who want your job, you dig? If you start taking losses, they see you as weak and shit." And I thought about it, and I said, "CEOs often pay themselves million-dollar bonuses, even when companies are losing a lot of money. And it never would really occur to an economist that this idea of 'weak and shit' could really be important." But maybe -- maybe "weak and shit" -- maybe "weak and shit" is an important hypothesis that needs more analysis.

Thank you very much.