Big Finance, Demystified

I'm here today with John K a fellow of St John's College at Oxford University and a visiting professor at London School of Economics we're here to discuss his book other people's money the real business of Finance is published by public affairs press welcome John good to be here Rob this book feels to me like the delayed answer to what happened in 2008 it takes a bit of time to sort things out and reflect on things but it's not cautious it's not marginal it's a bold statement about what Finance represents in our society and how it needs to change I I I hope that's right and we've had a lot of books in the last five years about what went wrong in 2008 and particularly narrative descriptions of the events of the crisis and that led up to it uh what I'm arguing here is wanting to take a much longer Loop and say that what what we saw in 2008 was not a kind of once in A- lifetime event it was rather the culmination of a process of financialization that had affected the whole structure of the economies of the West over 20 30 years and that's a development that is by no means over yet and it's gone deep into the heart of the way not just our financial sector operates for the way our business operates as well yes so we're not talking about a few bad apples in a wave of hubris though that was involved we're talking about a deeper structural critique about very major of valant that is right there were a few bad apples of course but in the main people are responding to the environment in which they're they're with with which they're faced and if people if people behave badly on a large scale and they did then it's not so much their fault as the fault of the the systems that produce that behavior and that's the issue we need to address so when you start how would you say like a detective looking for the clues of what went wrong structurally how would you characterize what you found what was the transformation of finance that is at the core of of which you say the vulnerabilities that were yes I right I began by saying that you know when I was at school in Edinburgh way back in the 1960s going into banking join in the Bank of Scotland or the Royal Bank of Scotland was something that you did if you didn't get quite good enough grades to go to a good University and if you worked hard for 20 years you would become a manager and you'd be a figure in the local community and you'd know the people whose money you were handling and whether people were worth lending to or not all that got swept away uh and we attracted much cleverer people into these businesses so that by the time uh these Banks the roal Bank of Scotland and the Bank of Scotland both went bust in 2008 and had to be rescued by the British government and by that time they were run by very smart people with Harvard mbas and good degrees from the best universities they were clever people but they weren't clever enough to handle the complexities of the environment which they which had been created around them and that's the key issue that the problems are not a few bad apples or a few people with hubris the problems are in a system that evolved in a dysfunctional way and gave opportunities for people to exercise that uh uh that hubris and didn't give wimpos enough effective restraint on the bad apples what kind of incentives inside the machine in in inside a banking or financial institution emerged that led to this uh kind of repid yeah I mean part of part of the problem with Finance is that as we've moved from a world center ground relationships the world I was describing of the the kind of oldfashioned bank manager and stock broker to a world that is centered around Anonymous transactions and trading you create an enormous bias to action almost everyone in the financial sector now gets rewarded for doing something you don't get paid for waiting to see what happens you don't get paid for patients so the result of that uh is that we have a a massive activity going on and incentives to create activity and much of that activity is of little or no value to the real purposes of financial services and what you see inside the firm about how you say who becomes the priority the old relationship Bankers were considered dinosaurs and and the new Traders Rose to the top management and if you study I know people at Business Schools and other have studied the structure of top management the Traders essentially took over that's right and we saw it very clearly in Britain where we we had a fairly sudden deregulation in 1986 what happened was that the retail Banks because they had huge capital resources acquired other Financial Services firms the retail Bankers it turned out didn't know how to run these firms and the culture Clash was very severe these these mergers didn't work but these firms remained conglomerates and what happened was the traders who were greedier and smarter eventually took control of the whole Enterprise now part of the problem we have here is that the culture that is appropriate to retail banking which is cautious necessarily bureaucratic to some degree which relies on processing millions of transactions every day with a very high degree of accuracy is really very difficult to reconcile with the culture of the the the buccaneering culture of the the trading room and actually what happened in the end was that the culture of retail banking was corrupted by the culture of trading people were finding they were on sales targets trying to generate activity regardless of the underlying needs of their customers and when you look at these internal structures and how things modified what happened in the realm of compensation what what were they saying to themselves inside who got paid for doing what well compensation went through the roof and what now part of what happened there was traditionally the risk-taking entities the investment banking and Market Mak making sides of um Finance had been conducted in Partnerships and in Partnerships uh you bear the people who running the business bear the losses as well share of the losses as well as the share of the profits that meant they typically made quite a lot of money but it was very volatile what they made and if things went wrong where they occasionally which they occasionally did they did very badly indeed and that of course meant the people in these organizations monitored what they colleagues were doing pretty closely because their money was on the line in the 1980s most of these organizations change to to public companies and once you have limited liability company that means you can take the upside but you don't share the downside in the same way and of course the transition to a a public company didn't affect the remuneration expectations of the people who are at the top of these organizations yes it yes so that you have a a situation where within Society the top 1% was increasingly populated by financiers but even Within These firms the proportion of compensation that went to the very top management was concentrated as well yes so I was staggered by the observation that the the share of the top 1% in income in the economy generally in Britain and the United States States has increased very sharply since the 1970s with the rise of financialization R first approximation it's doubled from about 8% to about 15% but when I looked at the structure of compensation in Barkley's bank I discovered that the the top 1% of employees there were taking something over 40% of the total remuneration of the bank uh and there there were a small number of people earning astronomical salaries and actually although popular opinion hates bankers at the moment uh the vast majority of people who work in banking are not being paid particularly well at all well they get co-branded with the superstars get co-branded but they're actually doing fairly mundane clerical tasks that make sure we get our salaries on time and are able to pay our bills and in the United States in the data that I've seen in addition to this say fling of the top 1% and the increase of the compensation of the top 1% or top one tenth of 1% we also saw non- Financial corporate management in what is referred to in academic liter as the principal agent problem where the management can't be disciplined by the collective of stockholders and they work with Finance years to extract more wealth through stock options and stock BuyBacks and the whole philosophy I believe Michael Jensen was really the backbone of of shareholder value there were two or three things happening there one was that as um the financial sector and the top management of the non-financial sector became closer people running real non-financial businesses started asking hey why am I not getting paid anything like as much as these guys especially since I'm generating a fair proportion of that business secondly the whole rhetoric of shareholders value and the idea that one should link uh managers compensation to share prices especially in the neara when share prices were mostly going up uh legitimized the explosion of executive remuneration and third I think there was a kind of cultural shift of when asked why did people who were running big companies back in the 1970s not pay themselves very large amounts of money there weren't as it were any formal restraints that stopped them it was just that wasn't how you behaved and that Chang MAA famously is the head of Ford Motor Company was paid about 14 times what the average uh worker made at Ford Motor Company about 1963 and they asked him once why aren't you paid more and he said well that would be shameful yeah you don't hear that from Top management and actually Robert mamara may not have made a great defense secretary but he was pretty good at running forward that's right that's right so now comes the question you you've identified all of these things happening within the industry but this industry is embedded within society and in two respects I'm very concerned one relates to we could we offer an awful lot of safety net and an awful lot of support to the financial industry on the grounds that that industry facilitates growth growth and productivity in our society is is that a a fair assessment or is this also a mythological well we have this idea that Finance is special and actually every industry I've ever talked to believes it's special but uh Finance is exceptional in the kind of strength of that conviction and is it because of the harm they can do in the event of a collapse as shown by 2008 or 1932 or um it could be but we have this idea that collapse in Financial in the financial sector is inevitable actually if I look at britan MH we did pretty well in avoiding Bank collapses right throughout the 20th century uh in the United States which had a very fragmented banking system suffered very badly in the Great Depression right the British banking system which was more focused and concentrated did not in the same way I think up to the 1970s we'd actually learned quite a good deal about how to handle these things but the finance sector goes on thinking of it of itself as special it talks to itself it has its own language most people outside the industry don't speak that language don't really understand what it does and we're clearly scared that it might collapse and take large parts of our social and business lives with it but actually the same is true of the electricity Network the telecoms network the water net the water supply and so on and we've managed to we've managed to manage these things pretty well they're in fact run by fairly ordinary Engineers who attach a very high priority to the robustness and the resilience of the system one thing I do in the book is I say don't we have quite a lot to learn from how these complex systems in other parts of the economy are operate operate and I think we do and this is one of the parts of saying no Finance isn't special we should look at Finance in the same way as we do other sectors of the economy we should ask what are the goods and services we want it to deliver how well is it delivering them and we should also say that if these activities can't support themselves without subsidies or guarant es or other support from governments then perhaps they shouldn't be happening yeah well the demystification of Finance I think can take on two forms we might call decoding the rhetoric but also looking again at structure what kind of benefits to productivity do we see I know adir Turner the chairman of inet's governing board has also written a book recently and he talks about how collateralized commercial and residential real estate has an awful lot to do with what the sector has done and things that produce which you might call the metaphor of the past manufacturing productivity growth are really not activities that this sector is deeply involved in any longer yes there are various things we ought to see see there one is to ask what do we actually want the financial system to do and that's a key question and in my view there are four things we want from the financial system we want it to operate our payment system so we can receive wages and salaries pay our bills and businesses can manage their transactions that's in some ways a relatively easy bit it's what most of the people are employed in the sector do and it's the essential utility we all need and if it broke down even for a few hours we would all have problems second thing we wanted to do is to help us uh manage our wealth over our lifetimes and between Generations third thing is capital allocation and I think not many people understand how Capital allocation operates in a in a modern economy first of all the stock market isn't very important as a means of raising Capital anymore that businesses big enough to have Stock Exchange quotations now generate more than enough cash for their investment requirements for their from their own internal resources and that's just as true of established Capital intensive companies like ex and mobile as it is for modern companies like apple which actually has more cash in the bank than any company has ever had in the history of the world and actually right most of what capital allocation is about in current economy is is housing in Britain 60% of the Capital stock of the country is houses mostly owner occupied in the US it's a bit less but it's nearly 50% it's a similar figure in France to the one in Britain Germany is a bit more like the the United States actually Housing Finance is the most important part of the capital allocation mechanism that used to be done pretty well actually in thrifts and small specialist institutions and there another example of these things where um it was done in a more complicated Way by clever people and it turned out in the end that it was being done a lot worse than it had been in the old old days where you were interviewed by a local manager who looked you over knew the area knew the house and was concerned about what your ability to pay it back and the final area is risk management and what people say about we need financial system to help us manage our risks and that's a rather strange world because if you talk to people in the financial sector they will explain how we've become much more sophisticated in Risk manag management over the last 20 or 30 years now that's a bit odd since first of all we've had even bigger crashes when this has happened than we've had before and that's again an example of the techniques have not improved enough to cope with the extra complexity of what has been created but more interestingly still the risks that people have focused on managing are risks that have been created within the financial system system itself yes we're not talking about acts of God or yeah that's right and the RIS the risks that concern Ordinary People a kind of Hurrican Katrina it's getting illness mortality relationship breakdown these things these are the things we need the financial system to help us with and the these sure aren't what the people on Wall Street and the city of London I'm thinking about this is growing your own your own calamities endogenous risk and congratulating yourself on your limited success diffusing but let's let's go then you have these breakdowns like 2008 and the pure free market fundamentalists suffer a little bit of egg in their face from such an episode but some people would have said okay this calls for the government but in the United States after we saw the bailouts the so-called tarp legislation troubled AET relief program and other things the public actually turned on the government and said you're an insurance agency for the rich and the powerful you're not regulating for the public you are enablers do we have a regulatory system now that is not up to the task that is captured by the power of the financial sector and is incapable of the reforms that we need and and the regulatory system we have is not up to the task and there's almost everything wrong with it I mean it's extensive it's intr inclusive it's largely captured by industry interests and it's ineffective in achieving the public interest objectives and what we have is a system that believe now public has reacted to that by mostly saying what we need is more regulation but we don't need more regulation of the kind that we've had indeed regulation is in large part responsible for aggravating the problems we've had because much of the complexity of the system has been generated by regulation and attempts to circumvent regulation we have to think about it in a quite different way because the truth is that this attempt to regulate an industry by writing very detailed rules uh from the center does not work and has not worked anywhere it's been tried the Paradox is if it would have worked then the Soviet Union might have worked and the Soviet Union didn't work because you couldn't run an economy by writing rules at the center yes and telling people to follow them what we have to do and what what you need to do in a market economy is you focus your regulation on the structure of the industry and the incentives of the people who work in it and that's what we need to do and get away from all these tens of thousands of pages that are now being devoted to the implementation of a dog Frank and to a rather depressing degree written by industry lobbyists isn't there also a dimension here what I'll call a moral or ethical Dimension uh I was very uh impacted when I read the concluding paragraphs of your book about in the depression when all of this blew up in the 1929 to 32 period we got to a place that was pretty much how you say on the Cliff's Edge of the end of democratic capitalism and we came back from the brink some bold leadership uh how would I say symbolized by Franklin Roosevelt in particular but you then you say we pulled back from that Brink but these are not games these are not Sports metaphors this is really at this essence of the fabric and the capacity for people to trust and believe in and participate in a society can we go on playing these cat and mouse games with regulation and lobbying and financiers acting like how would I say people are the prey and they're the Predator I don't I can't imagine how how do we get out of this corner how do and is it not as much moral or ethical does not a financier have to fear what will happen in the afterlife that's right I mean if we go it's a striking contrast if we go back to the 1930s where as you describe capitalism really was on the brink and it was actually luck and great leadership that saved capitalism from the Great Depression and from Hitler actually and uh we have some of these challenges and at least again again we have the challenge of as it were saving capitalism from itself and we also have the problem that because uh the public anger has no kind of focus or Outlet in democratic politics we see how the many voters are attracted to lunatics of all kinds from The Fringe of the the political Spectrum you have your Donald Trump we have our Jeremy Corbin yes they completely different in terms of their rhetoric but what they have in common is that they're saying the present system isn't meeting your needs and that resonates they rise on the tide of outrage yeah they rise on the tide of outrage that's exactly right and we need Democratic politicians with the leadership qualities that an earlier generation had who are willing to handle this yes and and we also I think need stewardship from private sector leaders this mentality that I'm not responsible to anything other than shareholder return something that Milton Freedman encouraged doesn't that put us into a very difficult Place particularly in a global environment where a finance year managing a multinational company can Arbitrage between governments to the pecuniary advantage but contributing to the disrepair of society I think that's right in a broader sense we need to understand that the large corporation is a social institution which can only operate by being embedded in the society in which it operates and its legitimacy is ultimately going to be judged and should be judged by what it contributes to the society in which it operates uh and it we have made a mistake pursuing this Mantra sholder value and more than that the Mantra of shareholder value has legitimated to a excessive extent the enrichment the extent to which these corporations are actually run for the benefit of their Senior Management and the financial sector is actually the one in which this this has gone furthest it wasn't Bank shareholders who did well out of the expansion of the financial sector in fact they were screwed like the rest of the population when things collapsed in 2008 it was the people who had made a lot of money in the years that ran up to it in remuneration and bonuses and options and didn't have to pay it back yeah the smart alec saying in those days was IBG ubg ex I'll be gone you'll be gone by the time they clean up the mess we've made right we just why I have a chat on the mechanisms of I'll be gone you'll be gone well from my perspective this is one of the most challenging books to the whole perspective and what you might call uh justification for Finance in this modern era that we've been living through and I'm I'm very grateful that you've what you might say penetrated this logic and explored things with such Vigor and it's my hope that many many people will read this and uh to use your opening Parable that the ox Will Not Die thanks Rob thank you

Channel: New Economic Thinking

Views: 21,731

Keywords: John Kay, Rob Johnson, Institute For New Economic Thinking (Nonprofit Organization), New Economic Thinking, Economics, Finance, Debt, Financial Crisis, Credit, Economist, Financial Times, Euro, Credit (Industry), Market, Economy, Book, Other People's Money, Business, Financialization

Id: sk7XOT0QXmM

Length: 26min 33sec (1593 seconds)

Published: Fri Oct 09 2015