Finance and the Real economy

I guess I start good morning no matter how you interpret it the title for this panel finance and the real economy could not be more timely nor could we have four panelists who are more knowledgeable therefore in order to get the maximum out of the short time that is available to us let me simply set the logistics each panelist will open with a 10-minute comment at the end of 40 minutes I'm going to ask them a few questions arising out of things that they have said and then I'll open it up for an exchange between them if one hasn't already occurred which I hope will happen and then as soon as possible thereafter after they've had the chance chance for a bunfight um I'll turn the questions over to you finally to show how important it is that we all be as concise as possible I'm speaking to the panelists I'm also speaking to those of you who from the floor who will be asking questions I'm going to deprive you of the brilliant uh preparation and introduction that I had prepared which I know is going to break all of your hearts and I'm going to confine myself to two brief comments all of us first of all have a role to play in the global economy this is true of hockey players it's true of the inventors of computer apps of professors of economists it is also true of the banking sector whose role is to be a trusted and I underlied the word trusted a trusted enabler of stability and of growth in the economy periodically however it reverses its role in the financial sector becomes a source of instability and when this stems from activities which many characterize as broken trust by the major players in the world the major Financial players in the world the result as we have seen is global contagion with devastating consequences this is what this panel has to deal with or to put the question in another context the financial industry's direct contribution to GDP in the United States is about 6% or half that of manufacturing it's about closer to seven in Canada yet according to the former head of the FDIC Sheila bear the financial services share of all us business profits which in the 1960s was 15% Rose to 35% during the 1990s and then a decade that follow grew possibly as high as 45% now if you agree that profits should primarily be the reward for creating value the question becomes did an industry which contributed about 6% to the GDP really deliver 45% of all the value created by American Business in the early part of this new century and if you don't agree well that's what makes this panel interesting over to you Ed Clark thank you Paul I'm not sure you've tilted this this introduction in my direction here so uh just delighted to be here and particularly honored to be with the uh the panel here really an incredibly distinguished panel I get that I'm here as a practitioner and by the end of the day you might decide that I was the perpetrator um but I thought what I would do uh is you know go over and I want to be clear in the sense at the start that in the fundamentals I agree with many of the points uh that the panelists I think will make I thought I should just spend a couple of minutes though uh on where the TD Bank has been on some of these issues because inevitably where you are and the broad policy issues depends from where you start with uh and we tried to build a TD a franchise model built on a very simple idea of what do consumers want uh and so work from the consumers and go in instead from the bank and go out uh and that basically means people want better service longer hours better locations and that's what we deliver and as it turned out and I want to emphasize that as it turned out in the world that we lived in over the last 12 years that was a good space to be and we've averaged compounded Total sharehold return of 15% a year since 2002 the best uh in the Western World in that process we shifted the model uh very dramatically TD Bank used to be 55% % earnings from its security dealers and 45% from the retail side it's now 90% retail and we made some decisive risk decisions we were a top 10 player in the structured credit derivative business and we exited that business at its peak in 2005 and 2006 because we didn't like the risk uh characteristics of it and took enormous hits in terms of our earnings to exit and a lot of criticisms from our investors for doing so we were the only Bank in Canada to refuse to sell structured asset back commercial paper to our clients and customers because we did not like the risk characteristics for them even though we were not going to Bear any cost of that and when we went in the United States we are now at top 10 Bank in the United States that we refused to do some Prim lending and again we're heavily criticized by our investors for doing that in building the bank uh we we built a security dealers which would be called a vocer dealer in today's language but did it long before this was in a sense inv Vogue uh and took out proprietary trading took out tail risk uh and said we should be in fact adding value one of the things that we did was we capitalized the bank about two to three times what regulatory Capital was uh required at the time and stress tested the security dealer to make sure that in fact it could not suffer loss uh in the financial crisis and it did not as I mentioned uh we did go in the United States we actually have more branches in the United States than we do in Canada um and when the financial crisis came uh I wrote an article that then ultimately was co-signed by all the bank cosos in Canada saying in the financial times bring on reform give us Force us to carry more Capital Force us to carry more liquidity because you we believe that in that sense regulation can be the friend of the well-run bank because it actually takes out your road players uh I don't have any slides today so I thought I would just quickly summarize uh the Five Points that I would like to make and then give slightly a bit of detail on each of them so I agree with the core issue that we have worrying Trends in nonproductive leverage in society and growing inequality I think there are technology issues globalization issues World savings and balance issues that are complex set of interchange things that are causing these things uh I think they're troubling what's not clear to me is how you move and solve those issues I think it's not they're not simple magic bullets for any of them I agree that there's been non-productive innovation in the financial sector but I would like to point out that I think there's been very productive innovation in the traditional old fashioned banking sector I think the banks made a terrible terrible error they should have felt terrible after the financial crisis occurred they should have apologized for the casino greed cultures that they built but I think it's also important to recognize that they don't own all the problems uh and and I'll get into this you have to look at public policies and the leaders of those public policies of what they were advocating at the time I also think it's wrong to extrapolate from the misdeeds of the security dealers to attack or old fashioned banking for excessive Consumer Debt which I should we will talk about I'm sure um I do recognize that all the PS recognize this but I think it's important there is a macroeconomic context here if you make a good cheap people use a lot of it we have made debt very cheap in society we should not be surprised that they use a lot of it and finally well politicians and policy makers must take responsibility for the environments in which they create in which business and operate clearly everyone in society struggle with how do you create business in National cultures where Business Leaders who in some sense by definition often have better access to what is actually going on in the economy can play a more positive role in helping to avoid bad public policy so let me just quickly go through uh and talk a bit about each of these points so as I said I agree we're pretty see we're putting on non-productive debt right now and did the gr uh the transformation of the dealers that start to occur in the '90s uh create excess risk I agree with that and clearly was much of that Innovation not in fact value added to the society but if you look at the basic banking business it's unbelievable the kind of innovation that's gone on that has made the consumer better off if I go back to my own company Canada Trust 1976 moved mov D to 8 to8 6 days straight in a world of 10 to3 banking today we're open 7 days a week we have calls ERS open 24 by7 in four different languages in Canada the mobility Revolution is changing banking dramatically it's changing banking around the world it's reducing uh cost transaction cost to the consumers we now have intelligent ATMs people can deposit their checks remotely through mobile devices if you look at the investment market today you know we can invest for less than $9 a trade we have ETF or lowc cost forms the invest TD offers an e mutual fund of almost zero margin really the consumer I think has an unbelievable opportunity to have dramatically lower Banking and dramatically better uh Improvement indeed I hope that's the case because we're as a bank are spending more than a billion dollars a year on initiatives but if they're not adding value to the consumer and to the economy then we probably shouldn't be spending that money I think on social issues I think Canada is different you shouldn't extrapolate necessarily from the US model to say it's the same I think the two models are quite different uh we've had a lowincome banking package for a long time in Canada we've never moved the price we enhanced that package on occasions we have guidelines on credit cards not legislation in change revenue on credit cards is 30 basis points less than the United States the five Canadian Banks plus clada trust build are interchange our debit system with zero debit charges interestingly the industry the retail industry has now come and said we would actually like to have some debit charges there because you're not investing enough in that and so there will be in fact one two basis points of interchange uh moved in uh in order to fund that investment M and if you take a look despite the fact that the Canadian system is more concentrated if you want to buy a CD buy it in Canada not United States uh the value that you get is much higher and if you look at lending rates uh they're they're about the same and if you look at things like overdraft again the system in Canada produces better value for the consumer I think the tougher area which I'm sure we'll get into is but are the banks to blame for excessive Consumer Debt or excessive real estate inflation again I think you have to be careful to to extract from the US experience and say that applies around the world if you take a look at what happened in the United States it is hard to argue the government policy and regulation wasn't actually at the centerpiece of what caused the housing boom Bernie Frank used to go around and tell all the banks we want you to do more subprime Lending we have mortgage interest deductibility in the United States we have these Central quasi government agencies that were huge players in developing and and contributing to this Market but that doesn't mean that Canada doesn't have an issue but it's a slightly different issue and I've spoken publicly about it significantly I do believe that the Canadian consumer is becoming too indebted now that's not if you take a look at the figures is actually not an unsecured lending so it does go to the heart of housing issue and so uh non-secured lending is in fact flat has been flat for years in Canada it's all to do with housing inflation and the Mortgage Debt the consumer takes on this is not a crisis about getting that mortgage paid back because of the nature of lending in Canada where we have very conservative standards of what we lend and so every time you do these simulations you see the banks don't end up have suffering significant losses in a housing collapse the issue is though that when consumers indebt themselves the society and the economy becomes more fragile because the consumer themselves become more fragile a big other difference between the two models can in the United States is that our regulation is principle base in the US regulation is detailed base we can get into this but I think uh what's clear to me is that in fact detailed regulation increase risk you create an environment where if it is legal you do it if it's not you don't whereas in Canada we try to force people in the business to actually think about what the right thing to do and it has been fascinating in the US to see what the political system which is the other difference is that the regulatory system in the United States is politicized and in Canada it is not and so you have a financial crisis that's built around housing and Money Center Banks and the first thing that that the politicians focus is on neither those both look too hard to solve and so you spend all your time on debit cards and interchange revenues and overdraft fees a whole set of things and you say that's where we will focus our attention and it's not obvious that in fact changing your interchange Revenue uh regime in order to make Walmart better off is a cure to the financial crisis and that's what happened in the United States gain to reemphasize I do think the macroeconomic environment matters and there I think we have to spend more time if we're going to run low interest rates and I think in the world we are for some time we have to think about what are the other instruments that we can use to lean against the inevitable asset inflation that such a policy creates finally you get to the I think is a nub of the issue here is the interaction between business and and public policy policy and what role do Business Leaders have to play in that and the reality is what makes business do well it is that the Simplicity of its goal structure the narrowness of its focus Business Leaders believe whether true or not that they simply live in a world and react to it they find Opportunities and they go after them they do not shape the world now that's obviously not entirely true and they clearly spend a lot of time trying at the edge to to shape that world to their advantage but the reality is that Business Leaders are successful because of the Simplicity of their gold structure now that of course means that they're probably not very good at talking about public policy and when you hear Business Leaders talk about public policies they generally describe public policies that are not what you might call good public policies and good business policies for self-interested widely defined and long-term defined they describe public policy and an interest of what is in their shortterm immediate interest that is the nature of the Beast your dealing when when you're dealing with business people and so how do you actually create a moral code that Business Leaders who do understand a lot of what's going on how do you actually extract that knowledge and have them interject in debates to talk about wider issues and to Advocate policies that may not be in their short-term interest interest but in factor in their society's interests I've spoken out a lot about inequality about rising inde deadness and I have to say that for some of my shareholders this is inappropriate behavior because it is not in the interest of the shareholders in the immediate term uh to do these things and so in many of the issues of the day excessive coo compensation no restraint on business activities I think reflect that in the world there has been a change in the moral code of what Business Leaders do and with globalization Most B Business Leaders believe that if in fact they intervene in these things they are not representing their shareholders and that we're in a world of Winner Takes all and those that don't play by the roughest rules won't be there to play at all how do you in that atmosphere shift it so that Business Leaders play a more responsible role because clearly I think they could have helped and lent against some of the excesses that have occurred and they're still occurring today thank you very much thank you very much Ed Axel well the responsibility of bankers and of polititions for the crash and so on has been noted over and over again I think I'd like to begin by noting that economic profession is not altogether innocent uh we economists have a lot to answer for uh in particular uh we invented inflation targeting uh we argued that keying on the CPI uh and letting the money supply uh being perfectly elastic Supply or Bank Reserves uh was was the thing to do and this is the policy that created the housing bubble and the policy that created uh the enormous Bank profits that were just mentioned secondly deregulation uh the regulatory system that was created as a response to the Great Depression of the 30s uh made the US Financial system into what I called in other occasion a ship with numerous uh watertight compartments that would not sink uh D regulation did away with all of that and made it into just a big bucket that uh uh sunk as soon as the hull was punctured in one place with consequences uh that we uh now know well uh of course that was the old economics and we are doing new economics here so we need not feel uh too responsible uh I want to bring up some of the distributive consequences of policy uh that I think have not received the attention that they should uh I have hardly heard heard them mentioned in in this conference uh when we build up or we allow an unstable web of contracts to be built up in the economy uh eventually some trivial event will start that unstable web collapsing into itself with defaults triggering more defaults uh if you do nothing you end up in the Great Depression so it's of the utmost importance to try to Halt that process before it's run its full course now to do that in principle you have to decide on what contracts should be carried out to the letters and which ones should not that is uh you would have to decide who will who must pay who will get away without paying who will get paid and who will not get paid and so on which is of course politically absolutely impossible to do so what do you do you try to stop the process and to reverse it by flooding the economy with liquidity uh provided nowadays at uh what 0.2% of uh 0.2% the thing to notice about this way of dealing with the situation is that it means doubling down on the policy that brought us into trouble in the first place it was the loow interest policy with a perfectly elastic supply of reserves that created the bubble and we are now trying to to cure the consequences by doing more of the same thing why why are we doing that well mainly because we need to recapitalize the banks it becomes the unique privilege of banks to borrow at the FED at 0.2% uh so that they can cross the street and go and buy treasuries at let's say 3% uh to build uh back their balance sheets the main advantage of this policy is that the general taxpayers do not understand it this policy doesn't just Accord a privilege to the banks as institutions it of course also Accords a privilege to the bankers and that privilege is to take home big bonuses based on the profits created by this particular and if I may say so peculiar monetary policy now that redistribute income from Savers that earn nothing now on their savings but who will be taxed uh so that the government can pay interest on the debt that is created in the process and that is held by the Banks and this uh raises a question that I want to to end on what happened to the vision of free enterprise of the free enterprise economy where everyone was paid his marginal product because this process that I have sketched has absolutely nothing to do with uh productivity the general taxpayers people in general may not understand uh the imaginations that are going on but they sense that something is seriously ascue and the result of that is that we get movements like the tea party in the United States and generally an instability of the political process thank you thank you Axel Joe well it's a pleasure to be here uh even if it's the talk about a a a very depressing subject um I'm going to talk about finance and the real economy and I'm going to begin uh by just reminding uh everyone here about the essential functions the workings of of a uh of the financial sector uh in the workings of a mo modern economy uh and that includes the allocation of capital uh providing credit uh managing risk running the payment mechanisms globally it it entails recycling the surpluses from the say the Surplus countries to uh where in the world the there's a need for uh additional funds um it's absolutely critical for the success of the economy that these functions be performed well and efficiently and that goes to two points that have been emphasized in the meetings of in since the very beginning the fact that the financial sector is not an end in itself but a means to an end you don't uh directly enjoy uh Financial Services it's it's not the food you eat it's not the clothes it's not the culture it's it's uh a means to uh the overall economy achieving other objectives Ives and in that sense the financial sector is supposed to be the servant of the rest of the economy but in fact it seems to become the master and in fact in many countries before the crisis everybody talked about uh the wonders of the growth of the financial sector as if that was the mark of the success uh of an economy well in the aftermath of of the crisis we all re recognize the failures uh they failed in absolutely every Dimension they misallocated credit uh Capital they didn't provide adequate credit for new job creation uh new Ventures uh and interestingly while parts of say the America's Financial system have been praised like venture capital in the area of small and mediumsized Enterprises credit to small and mediumsized Enterprises five six years after the crisis is still about 20% below what it was we really haven't gotten the financial system to work in the way that it's supposed to uh it's also very clear that the financial system didn't manage risk in fact it created risk and while it wasn't doing what it was supposed to it was not doing the things that it was was doing very inefficiently it absorbed a very large share of GDP and some of the most talented individuals in the country one of the I would say sad things as a teacher is to see so many of our most talented students going into Finance rather than into more productive activities ones that would give them more satisfaction and contribute more to our economy and in spite of absorbing a larger fraction of uh GDP as was already pointed out and fite of an enormous share of profits of Corp the share of corporate profits of 40 50 60% before the crisis uh there's very little to show for it in terms of overall economic performance in fact uh I would argue it's a negative sum game their returns have been largely at the expense of the rest and it's one of the reasons that the standards of living of most Americans have stagnated for decades so you know since there have been these huge consequences from for the failure of our economic system uh the failure of the financial system is contributed uh in a very important way to one of our major problems are growing inequality to the low growth the high instability the high level of indebtedness of of the government we can engage in a a long debate and we don't have time here uh to talk about was the banking system itself was it The Regulators was it the economist uh was it the Monet AR authorities but I think what we can unambiguously say that uh the financial system whatever the cause didn't do what it was supposed to uh with enormous consequences uh for our whole society well uh that leads to the question uh what before I coming into the question of of how do we explain it I want to give uh one example which is our payments me mechanism I choose it not because it was one of the central pieces of the crisis uh clearly some of the things I'm going to talk about in a few minutes are much more uh at the center of the crisis but it shows in a very simple way uh the way the dysfunctional nature of our financial system uh what I'm talking about is uh a major source of the rents uh that acred to the financial system and a major source of distortion in our economy and that's the payments mechanism you know in in elementary economics courses we talk about the role of the financial system in running the payments mechanism well it should be possible with modern technology to have an efficient electronic payments mechanism the cost of transferring money from one person's banking account to a merchant when he makes a purchase should be minuscule and yet the credit and debit card companies regularly charge 1 2 3% or more so it's like a tax on every tax action but at tax that goes to enrich the banks and the credit card companies rather than for public purpose uh some countries have figured out what to do about this uh United States and do Frank they did a little bit on the debit card uh but then they made a critical mistake they turned it over to the FED to enforce the regulation and uh the regulations that the FED introduced were so outrageous that the court threw them out well we could get again huge topic but what I want to move on to now is uh what is the underlying problem the under underlying problem is a very simple one there a disparity between social and private returns social and private returns of organizations and of the managers of the organizations in terms of organizational incentives the problem is not only too big def fail which has been talked about uh here but also to interconnected def fail to correlate def fail uh and fact that much of the profits are achieved as a result of predatory lending abusive credit card practices Market manipulation exercise of monarchic power as in the case of the payment mechanisms and the disparity between social and private returns of managers uh including incentive structures that encourage short-sided behavior and excessive risk taking all of this of course you have to ask the question we thought that one of the strengths of the market economy was designing good incentive structures why did they design such bad incentive structures and the answer of course has to do with failures of corporate governance so the the result of this is that uh we have a financial sector that has been doing what it hasn't been doing what it should and has been engaged in doing what it shouldn't one of the themes of this conference has been on in Innovations and the same distortions that I talked about before arise in the nature of Innovations if you have a disparity between social and private returns you will have disparities inefficiencies in the design of Innovations so the Innovations in the financial sector were more focused at exploitation at circumventing the regulations uh this reminds me of of of the comment that Paul voker once made where he said that uh he couldn't think of a single innovation of America's Financial system that had led to the increase in productivity uh increase of well-being other than the ATM machine and he was wrong because the ATM machine was a British Innovation so yes there are important Innovations of longer hours and being more focused on consumers that uh were talked about but those aren't high-tech Innovations those were just being responsive to to the needs of customers which you expect every organization to be function there AR those aren't the the sophisticated products that uh enticed some of our most talented individuals to come up with like high frequency trading and I'll say a word about that in a minute so uh when I look at uh what's going on uh I'm not surprised that uh the system hasn't worked as well partly because as I say there's been a a uh Distortion between private and social returns but there's also been basic confusion about some basic concepts and of course it may be that this confusion about basic concepts is um a natural consequence they didn't want to learn what was not in their interest to learn so there are four examples I've given here the first is is probably the most important idea which is underlying a lot of the behavior in the financial system is the belief that any action between two Consulting uh two two consenting adults is okay it improves societal welfare but that perspective of course ignores externalities ignores all the kinds of issues that Michael Sandell talked about last night uh ignores the consequences that those actions may have for the fundamental trust in our economic system so the kinds of of products that say gold MCHS produced that were designed to fail undermine clearly trust in our system but there's a more General result Bruce Greenwell and I had a very general theorem showing that when there is imperfect and asymmetric information and imperfect risk markets markets are not in general efficient there are a host of externalities that arise and work in including an an an uh a task force at inet has been exploring some of the implications for what are called macroeconomic externalities and these really make a big difference one of the reasons why it's important to have a regulated Financial system the second is that I find it striking that how many financial institutions don't seem to understand the most important theorem in finance and economics the mugani Miller theorem they sort of believe that the more leverage by creating leverage you create wealth out of out of nothing out of thin air whereas of course the main concept of mgan Miller theorem is that if you create leverage you're just shifting risk from one place to another you're not creating wealth out of thin air and of course you what you're doing really and the too big to fail too connected interconnected to fail uh too correlated to fail what you're doing is Shifting RK risk into the public sector the third and fourth examples I want to give are issues that have gotten increasing attention particularly since the publication of Michael Lewis's book on high frequency trading some of us have been concerned about these for years um one of the justifications of highfrequency trading is that it increases price Discovery but none of the people who've advocated that have ever shown that actually makes a more informative price system in fact what I've shown using a a coral are of the rman Stig theorem is that in fact high frequency trading reduces the informativeness of the price system but the real issue is these are examples this is an example of uh the financial sector not really take into account what really really matters it's not what happens in one nanc versus another but whether the price system is really working to reflect the values of the fundamentals underlying and the fourth one which Lord Adair Turner has talked about a great deal a failure to understand the theory of the second best the notion that completing the market there's been a big uh agenda of completing the markets but we know from the theory of second best that unless you go all the way to having a full set of aerody dew Securities you aren't sure that you are going to improve welfare and there are an ample examples of theorems in economics showing that in fact you can make the equilibrium inferior by adding more markets and in fact the agenda of completing markets has actually increased uh the instability of our economic system so the the the the general point I want to make is that uh these are all ways in which our financial system may have had Innovations but not Innovations which have actually increased the performance of the economy I said before that part of the problem was that a disparity between social and private returns and one of the objectives of regulations is to design reg uh uh to to impose constraints and incentives that help align incentives to encourage financial sector to do what it should um and constraints to ensure that it shouldn't do what it shouldn't and it's clear that we've had a a regulatory uh failures but a couple points I want to make the first Echoes what was said last night by Michael uh sandel which is the problem of compliance the notion of the fines for not doing what you're supposed to do or doing what you shouldn't do uh are supposed to be a signal that you aren't doing something uh that you you're you're doing something that is being viewed as being being socially sanctioned but our banks have taken the view that fines are just the cost of doing business and if you can get away with it that means that your profits are all the greater uh so you look at what banks like Wells Fargo and almost every major Bank engaged in practices that have long been socially sanctioned uh without either accepting or denying Wills Fargo paid a huge fine for engaging in racial discrimination This is 40 years after the United States passed a law against racial discrimination uh and yet you know that they discovered that racial discrimination increased their profits because on average they were financially less sophisticated and they could be better exploited so shareholder value means you're obligated to your shareholders to do that uh and they did it not an not really adequate AP poliy ol ology for what uh they did um a whole set of abuses have come to light almost every day you pick up the financial time and there's a new set of abuse and the answer is it's just a cost of doing business uh even a $500 million fine is minuscule compared to the profits that they could have made even lying to the court saying that they had inspected the records to see that the uh mortgage uh the person who owed money actually owed the money they lied massively to the corks not a ounce of a really apology and uh they uh then paid a fine but in fact they then circumvented the fine in ways uh to just continue the kinds of abuses that they had engaged in well uh we have to really think about how do we get better compliance when we think about getting a financial SE sector that actually serves the real sector I think we may have to also think about a larger role for government for a long time there's a presumption the government can't do many things uh there are government failures but as we saw in the financial crisis there are market failures no government or almost no government has lost misallocated resources and lost money on the scale of the US financial markets there are many successes and I can go through many successes in public sector Enterprises what is clear is that the private sector has strong incentives to do what George aof has called fishing for fools making profits by figuring out who is the easiest to exploit it may be the case that public Banks engaged in lending to basic consumer lending mortgages smmes may do a better job they certainly have a different uh objectives there are many examples of uh successful development banks in the US financial crisis the New York State mortgage Authority performed perfectly well unlike Fanny May and Fredy Mack that had been privatized in 1968 and that was because the Public Authority kept its eye on the ball of what it should be uh uh of what a social function was in conclusion let me say I believe it is possible to create a financial system which better serves the real economy that kind of a financial system would have Innovation that enables uh uh the system to really serve the real needs of our society better and in many ways some of the Innovations in technology today enable us more effective regulation so the question is not whether we can create a financial system that better serves the needs of our society but will the politics allow it thank you thank you Joe and there good morning every body it's a striking fact that over the last 50 years Finance got much bigger across most advanced economies the broad figures for the US set out for instance in Robin Greenwood and David schar Stein's paper is that in 1950 the US Financial system accounted for about 2 and a half% of US GDP by the mid 1970s about 4 and a half% and on the eve of the crisis about 8% of GDP and as Paul has said on some other measures such as gross operating Surplus or Equity value much higher percentages than that and Andy haldane's figures illustrate the same figures for the UK in addition the financial system has drawn to itself High talented people but paid them an enormous amount of money even more than you can explain by the amount of talent so the the analysis by Thomas philippin and Ariel RF shows an extraordinary excess of what you would expect to get for the skill levels of the people in that industry an excess which has varied over time it was about 70% above other sectors of the economy in the 1920s it then fell to about 0% in the 1950s and 60s but by the eve of the crisis it was back at 70% so we have a large and growing sector of the economy paying its participants it's its producers a large amount of money and we have as Joe said to ask question about that we can't simply accept that this is okay in the same way that we would uh if say the restaurant industry grew if the restaurant industry grew from 2% to 8% of the economy we would say well that's because people like buying restaurant meals but nobody gets up in the morning and say oh what shall I do today I think I'll go and consume some Financial Services that'll well there may be some people in this room who do that but most people Mo most normal people don't do that it it it's good if it is performing good functions Visa the economy not if it is not so we have to ask searching questions about why Finance got so big what it is doing and whether that is valuable now again Greenwood and scharstein have done a very useful exercise in breaking down the growth of the US Financial system into what constitutes it and it's useful to divide what has occurred into two elements one a change in what the financial system does Visa V the rest of the economy I actual services to the rest of the economy and what it does in itself if we focus on what it does Visa the rest of the economy you find some things which have grown but no more than you might expect like insurance insurance services have grown because we've got more things to Ure but actually the growth of Finance Visa the rest of the economy is dominated by two things one is credit the financial system makes money out of the net interest margin on credit and the fees related to credit origination because we borrow more money in the US in 1950 private credit to GDP was 50% it rises relentlessly to 170% by the ease of the crisis because we borrow more money the financial system makes more money uh out of us the other thing which is of course linked to us indeed it's almost just the flip side of this on the other side of the balance sheet the industry makes much more money out of asset management in all its many characters mutual fund fees uh private Equity fees uh hedge fund fees and brokerage commissions and VAR ious forms of trading and of course if there is more credit there's also something more on the asset side which has to be managed so there are more services to the real economy but the other striking feature of the growth of the size of the financial system is that it's doing an enormous amount of things apparently with itself if you look at a bank balance sheet from 1950 you can understand what's going on you will find that there are loans to the corporate sector or deposits from there are loans to the household sector there'll be some liquid assets held in government bonds but the bit which has relates to the real economy will be the majority of the balance sheet you can understand it if you look at a major trading Bank day now the Goldman Sachs or the Leman Brothers as was or the JP Morgans or the Barkleys the vast majority of the balance sheet has to do with trading Visa V the rest of the financial system it has to do with prime brokerage relationships it has to do with enormous amounts of interbank placements and one of the striking features of what's occurred is this amazing increase in intra Financial intensity in trading volumes trading volumes have increased dramatically relative to the real economic activities to which they create and we've created an entire infrastructure of contracts such as derivatives uh and structured credit which didn't exist before now the pre-crisis Orthodoxy was that both these developments the rising intensity Visa the real economy and the rising intensity within the system were good the rising intensity Visa the real economy was good because credit to GDP was a positive thing there's a lot of Finance theory that suggests that and argues that for instance India or Bolivia don't have enough credit to GDP there was a broad proposition in favor of financial deepening as for the increase in intra Financial intensity that was justified essentially and Joe has suggested already as a sort of hand me down from the Nirvana of bliss of the arrow deu General equilibrium analysis if only we all just create as many contracts as possible complete all markets and trade uh continually between all the different agents we will arrive at the par efficient a a maximum possibility o o of human welfare and that belief was embedded in a set of language and I think this is an important point for us generally in inet a set of language which rhetorically constrains the debate language such as Market completion well you wouldn't want to be in against Market Completion things must be better if they're more complete not less complete liquidity liquidity is always better price Discovery how could you possibly be against discovering things or credit which Mr and Mrs ordinary Joe want to build their business the crisis showed that that wasn't true that we cannot have confidence that this system was generating as was asserted both greater efficiency and uh greater uh St ability I think there are two major issues we have to ask about the financial system one is simply about efficiency and value for money and we can focus that question on all this amazing in financial system activity this trading activity this contracts these more complicated as axel said web of relationships within uh the financial system the axiomatic Assumption of neoclassical economics and the pre-crisis Orthodoxy is that it must be adding value because it is completing markets but Joe stiglitz his work above all has helped us understand that that ain't necessarily true that more trading under some circumstances can be excessive because trading in financial instruments is not trading between two people who have different consumer preferences or production possibilities it's trading between different people with different points of view over the state of an uncertain future and that is different more trading can be harmful and it's also not true that more Market Completion and Joe has said it already is necessarily good you create a CDS which is capable of hedging a risk but the very fact of creating a he a CDS which is capable of hedging a risk enables other people to bet in a way can that can destabilize the economy and so there is a possibility that we can generate within the financial system and essentially as was discussed last night between Kier and Michael Sandell a casino Act AC ity of course it raises the question as but why does that casino activity why does get it survive if this is a zero sum trading game between people why don't the systematic losers leave the game and why does it matter to the rest of us if these guys care to go off into a casino and bet against one another Well it matters because that casino is to a degree kept going by a set of rents which arise in the retail end of the system and in the relationship between the retail and the wholesale the scale of the asset management fees and the imperfections of the ability of the ordinary consumer to buy in a high in an efficient fashion so I think there is a reasonable argument that we're not getting value for money that we are getting a proliferation of activity which is performing the fundamental function of intermediation more expensively than it needs to do but it's not the biggest issue suppose that 8% of GDP didn't need to be 8% suppose we could have done this function for 6% of GDP well we're on average sort of 2% worse off but we're 10% worse off in all rich developed economies compared with the trend because of the crisis of 2008 and what that tells us is that the much bigger issue is the instability if issue the value for money issue the wasted activity the activity which isn't required is an important issue but it is not as important as the instability uh issue and I think it's clear that greater Financial intensity made the system more unstable but in a way which really poses very difficult issues at the interface between Finance Theory and macroeconomics because when I think we get to the drivers of instability the most important drivers are not actually the intra Financial system intensity I think they're important I think inra Financial system intensity created what I call the credit cycle on Ste steer oids a hard wiring of instability in the way that people like Marcus Brun and H Shin have described a a way where why we used things like value at risk and Mark to Market and secured financing in a way which made the system unstable but while that inner guts of the system the web of contracts is important the even more important driver of financial instability is simply Rising leverage of a particular form and a particular form on which finan an Theory and macroeconomics has been entirely silent or mainly silent or to the extent that not silent it has been wrong if you pick up most undergraduate textbooks and we were talking earlier this morning about the role of what we have to do in teaching undergraduates and graduate economics and they ask you see how they describe the role of the banking system they make two mistakes first of all they describe a system which takes money from Savers and lends it to Borrowers failing to realize that the banking system creates credit money and purchasing power abono denovo and with an important role therefore within the economy but also again and again it says well what banks do is they take deposits from households and they lend money to businesses making as Joe referred to earlier the capital allocation process between alternative Capital Investments as a description of what modern advanced economy banking systems does this is completely mythological this is very well described in a forthcoming paper from Alan Taylor and moris schuleri reflecting some inet sponsored research basically in advanced economies 80 85% of our bank credit is not to do with funding capital investment it is funding two things it is funding either consumption that may be valuable but we need to understand why that is why a funding a consumer credit would be valuable to what extent and the vast majority of it funds real estate sometimes either residential or commercial sometimes that is funding new real estate investment which is a form of investment in the economy but most of it is funding the purchase of already existing real estate and it is fundamentally funding in a credit form a competition between ourselves for the ownership of locationally specific Urban Land and that I think is absolutely fundamental to the instability cycle because it is that competition for the ownership of existing real estate and of locationally specific land which is in relatively fixed Supply that creates instability because if you put together the fact that the banking system that can create infinite quantities of credit and money and purchasing power and that Urban Land which is locationally desirable is in fixed Supply whenever in economics you put together something which is infinite and something which is fixed you get an inherently undeterminate price we have at the core of our financial system something which is bound to create inequality bound to create credit and asset price cycles and Booms bound then to create crisis and debt overhang and the balance sheet recessions about which Richard coup has talked so uh importantly that really poses a fundamental challenge because it means that we have a free market system which left to itself will create a problem not just of a dead weight cost of too much activity in intra Financial activity that we don't need but will also create too much of the wrong sort of debt but with the irony that each one of that debt seen as its own looks perfectly socially useful how could you deny that somebody borrowing for a mortgage is socially useful but the collective impact of it is something which is incredibly difficult for us to manage and a fundamental problem at the interface between finance and macroeconomics thank you well thank you very much for that adir that was very good in fact all of you let me I'm going to now ask each of the panelists a question I would hope that they could answer the question as quickly and as concisely as possible and then we hopefully we'll get into an exchange either because one of them has said something outrageous in his opening statement or in the answer to my to my my question so the first question I'll put uh and I'll put the questions in the order which they spoke I'll put it to to Ed Ed the banking system has gotten a bit of a rough ride up here in the last in the last little while I predicted itct I don't understand why the um but the fact is that didn't help no uh William Dudley who the who probably is as close to Wall Street as any public servant could be said that there's evidence um of a deep-seated a cultural and an ethical failure in many large financial institutions the fact of the matter is that Canada's Banks did not suffer the way that the US the UK and the European Banks did we in Canada talk about the cultural difference in our banks can you elaborate on that sure uh so let me make uh two points and then I if I if I can chair will allow me here I'll also do a little reply to the three speakers um so I I you know I think you have to start with a view which I do is that uh cultures can outrun business models and so if you look at at the company level business models create the culture necessary for their success and so I think as you moved in the 90s the the Securities industry moved from being franchise play that said our basic job here is to make our customers and clients better off to the casino play where your clients became counterparties you develop the culture I think there was also I think this complex topic but clearly we've moved a moral Norms of what are acceptable compensation to to different levels than we had ever had before and so you combine those two you create a culture that I think is at the heart of and they matter cultures matter in the flip side if you have the right business model then culture is enormously important because we say you know we would have 85,000 FTE but that means close to 100,000 people working for us a culture defines what people do when no one's looking and it's very important that our people do the right thing when no one's looking and so I think they are enormously possible yes there are cultural differences between Canada and the United States but I think part of those are formed out on how far Canadian businesses or Banks transform themselves the way other Banks did and that was last developed in Canada as I said we were in one sense the most developed and we purposely chose to get out of it and that clearly defined our culture I also think in general you in a small country you have a sense that you can outrun your country uh now you could say the people running the Icelandic Banks didn't seem to have that they we could actually destroy our country but I'd say in general in smaller countries you do have a sense of community and in very large countries that's hardly hard to produce and there's clearly a difference I mean the interesting things is 90% of the times Canadian moan that their banks are too conservative and they were happy when they were too conservative than there but there is a general feeling in Canada that we'd like a more entrepreneurial society and we don't reward entrepreneurship enough but it does have its advantage that we're more culturally if I can just you know take the the the list of where we're going where I agree and don't agree is I do think we're creating non-productive leverage so I think this basic notion that we're doing a lot of lending that's only re you know really creating asset inflation is a core issue uh I it's not obvious to me though in a macroeconomic environment where everyone is saying I mean Mr dragy isn't saying well I should actually raise interest rates to slow down this asset accumulation it is interesting to see that different countries have different impact so the inflationary impact in Germany of running these policies hasn't been as large as it was in Spain when you ran these policies and Spain differed very different from Portugal so I keep going back to if we're going to run and make debt free which is what we have done we're going to have to come up with better policies to lean to it and to assume that the bank system if I have a mortgage Salesforce out there and the team leader says every time we have a you about to originally another mortgage I want a team huddle where their household debt is too large in can I mean it isn't going to happen you know and so I do think governments have to step up and say Here's the kind of policies we want to shrink the banking system shrink the banking system I guess the other where is is that people move to say okay the banks are inefficient I don't see any factual data of that I don't see that the real cost of banking is gone up quality adjusted I think if you took the banking system today and went back 30 years ago and say what does the consumer get today for a basic banking account there's been tremendous productivity increases if you look at investing what we used to pay for investing as I say you could basically buy yourself if you're sensible ETFs that basically say you can have a diversified portfolio for free in cuss nine bucks and you get your custody forever for that we've taken the cost down I think you're going to find on the Tren you know in the exchange system we are going to find the Bitcoin kind of technology is going to take intermediate transaction cost to zero and that that's what's going on here so I think in the basic banking system we've had tremendous and positive Innovations thank you Ed I I would also hope that the other panelists would take advantage of when they you my question comes to use it as a they want to go after any of the others um uh in in any way shape or form except you're not allowed to criticize the Perfection that exists in Canada the um Axel um City Group twice uh Goldman Sachs once albeit not to the same extent B of A the same thing were failed to convince The Regulators uh that they had the margin that were necessary uh to increase dividends or to engage in share BuyBacks uh I think the question is is this simply part of a a tougher process and people getting used to a tougher process or is it that these big Banks don't get it I don't think they got it um the the fragility of the system uh it's mostly a matter of very high leverage and of course uh uh stretch maturity uh and uh the the problem we have in in trying to bring this the system back to a more robust state is very large partly I think a matter of um of creating a system where where Leverage is is controlled um I I took up two topics before and if I may I I'll come back to first one was we got into trouble by inflation targeting and the second one the trouble was so serious because of the consequences of deregulation what are we going to do about those two things um one inflation targeting I'm when I was a student which is 60 years ago um or 55 years ago uh we read Gan Shaw and Patinkin and the discussion among those uh uh resulted in the doctrine that for E for monetary and financial stability policy needed to control one money stock and one rate of interest in practice uh in the era of of monetarism the whole Focus Focus was on controlling the quantity of money and you did control the rate of interest um this thing was relinquished in the n in the '90s we went from Milton fredman saying controlling just the money stock to Woodford saying just focus on one interest trade and um and that has failed us so what mon what we need to do in the area of of monetary policy is we need to bring back some measure of quantity control instead of just having an infinitely elastic supply of Reserves at whatever the rate is uh the second one um was de regulation um I think it's not very hopeful particularly after delving into do Fran a bit that we find a a reasonably uh simple regulatory structure uh what I think the bubble shown is that incentives in the financial system have been badly skewed uh the system has played a game or have been allowed to play a game of I win you lose uh uh and um we have to do something about that incentive structure what would that be well the point is in finance you have not been liable for the bad consequences of what you have been doing uh the banks are bailed out and the bankers are are bailed out as as well before the Great Depression uh US Banks had unlimited liability um so a bank failed and uh and the bankers were liable for uh uh for the consequences uh we then instituted a pro a uh policy of regulating the banks by reserve requirements rationing reserves imposing uh uh reserve requirements and so on and uh and we relinquish this liability bu in part because it turned out uh in the end we couldn't enforce it we couldn't make the bankers paid for what what they had created uh well today I think the incentives in the financial Industries are are skewed as I said uh I win you lose uh and the way to cope with that may not be to impose this enormous Welter of regulations in in in do Frank uh but it but we should think again about uh liability for consequences um and that could be done for example uh by um the compensation schemes in the bank Banks uh where uh when the bonuses are given uh but for some duration uh those bonuses come with a double liability provision or a triple liability provision can I just add add yeah add one thing and it picks up a theme uh that's already been uh talked about in general Bank regulation May requ require uh uh using more than either just the interest rate or the money supply uh for instance restrictions on the amount of real estate lending that would that would direct some of the problems that we want to know where the money is being used that has societal consequences and the Neo liberal view was just call out of price and there are no macroeconomic externalities associated with how that gets allocated they know better than anybody else so I think that's one important change in the regulatory framework of and we used to some countries used to do this uh because you know developing countries did it as a regular basis because they said we don't want just to have people creating a real estate bubble we want jobs and they were told not to do that but I think we should learn from some of those successful developing countries the second point before the uh uh uh uh we we were talking about one of the differences between Canada and the United States is principle-based regulation uh and then not idea and this is also in the to some extent in the UK you try to figure out what the regulation is designed rather than write down lots of details uh in our legalistic system in the United States you write down details and then they always are trying to get around it at the and and and and and Arbitrage at the margin and that kind of system is really hard to run that that's very good and I I hope Daren might pick it up when I ask him a question just but before I go to with there I'm just going to ask you just one if you could be as quick briefly as you could at the end of your remarks you talked about uh the whole question of the huge profitability of the bank of the banks making large fines by large settlements not all that important fact of the matter do you think that if instead of settling there were en larged open transparent and long during court cases in which reputations were really the consequence of the of the settlement do you think that would help I'm G to ask Joe and then I'm going to go to w for a different question then I'm G to open it up to wer well as I commented my talk the curring system has the banks viewing the fines which are negotiated in which they never say uh guilty or innocent uh you know just we pay the fine $500 million you sort of think that there must have been at least some evidence that they were guilty if they're going to pay $500 million or or a billion dollars um the cost of those fines is borne by the shareholders not by the managers who've made the decisions it's even worse than that that uh even if the managers had to pay it's the previous managers who made the decisions got the profits and this is the point that Axel was making you really have to have callbacks to make the managers responsible part of the problem though is they make so much money in the period in which things were going well and the probability of getting caught is so low that it's very hard really to make them accountable without prison sentences now I don't think long drawn our battles will will uh help that much because it's an unev uneven Battlefield uh the political process has so uh uh restricted the availability of money to Department of Justice the SEC whereas the banks have you know wor chest of really literally hundreds of millions of dollars in legal so it's an un unlevel playing field and it seems as if companies like Goldman Sachs and and you know accusations that come in every day in the financial times it just goes off their back they they know that a story today people will forget about it in 5 days time yes there's some reputational risk and you know there are some banks who say I'm going to play a different game and are trying to say okay we want to deal a good reputation but the others are saying look at you know this is this is part of life uh in the big city and we're playing a high stakes game and uh so I think it really the only way you're going to get it is having individual accountability all right thank you there what I'd like to do is you you attended thanks Joe you wanted to to come in on that last and by all means come in on that last I'd like to ask you a question and you figure out how you're you're going to handle it one of the things I found very interesting in your own writings and you mentioned it up here was the fact that that uh you feel that we need credit growth faster than GDP growth if in fact we're going to have an optimally growing economy and uh and then you say that that inevitably leads to crisis and it leads to postc crisis recession session I believe having looked at one of your papers you announced you were on your way to China you may have been in China recently China's got excessive credit growth do you what you think that's going to lead to the same conclusion well I think the question as to what is going to happen on China is probably the biggest issue in financial stability over the next uh five years I mean if this China credit boom would to go on and not crystallize Now by 2020 you would have a 20 trillion economy with 250% debt to GDP ratio which is $50 trillion of debt if there's been Capital liberalization and by that time it's linked into to the rest of the world uh we are looking at a potential for a a credit crisis on a massive scale but to pick up your your your general Point Paul I mean you're quite right I have posed this question of why is growth so credit intensive and why does it appear to need to be so credit intensive to set out a sort of stylized fact for the last 20 30 years Rich developed economies have grown with ninal GDP growth rates of about 5% but they've had nominal credit growth of about 10 or 15% which necessarily means that the leverage ratio relentlessly Rises and I think eventually produces a point of a Minsky moment a crisis and a post crisis overhang and that does pose a fundamental question for us uh which is did we need that credit growth to achieve um that nominal GDP growth I.E a rate of growth of inflation of about 2 2 and a half% and real growth if it is if if we really needed that credit growth to have the nominal GDP growth then as Minsky once said uh we do not have an equilibrium in a monetary economy with capitalist financial institutions as against in a arudra valan seed and corn uh barter economy um I believe that there are things that we can do to have a less credit intensive model of growth but they require Things That Go Way Beyond the remit of central banks and financial Regulators they have to do with uh both the role of real estate within our economy but also crucially the role of inequality because I think one of the things that is driving the increase in the credit intensity of growth uh is an inequality effect if I can then link that to Ed's point there was something Ed said which I completely and utterly agreed with and and and totally agreed with and I think he put it beautifully which is in this area of if we believe that we can have credit Cycles which are out of control and we want to constrain them we cannot possibly ask the guys who are selling mortgages to take responsibility for it as you put it you can't expect them to go into huddle and say oh my God you know Mrs X wants this mortgage seems to be right for her individually but wow you know there's this sort of you know fallacy of composition going on here I've got to think this through you've got to to have that at the level of uh public policy and we have got to constrain the credit uh cycle in public policy you cannot do that and that picks up what Axel says through the inflation Target the inflation Target unlike what vixel sought vixel sort that provided we hit low inflation by having the nominal interest rate in line with the natural rate of interest all would be well I think what we've learned is inflation targeting is not sufficient we need to pay attention to quantity Aggregates but need to pay attention to them for a quite different reason from what we thought back in the 1970s and 80s there was a time when we thought that we'd got to pay attention to quantity Aggregates on the liability side of the bank balance sheet which is money because it was a powerful forward indicator of inflation in fact we pretty soon realize that money is not a good forward indicator of inflation but instead the credit aggregate I mean it's just the other side of the balance sheet is a good forward indic Ator of future crisis and post crisis recession but what this does mean is I think we do have to alongside addressing some of the fundamental drivers of the credit intensity of growth like inequality we have to have an approach to Central Banking and macr Prudential regulation which is paying attention to the overall leverage and rate of growth of Leverage and where it resides in the economy and as Joe said by constraining it by some policies which some of the develop in world have been using like loan to value ratio on uh limits which pretty much for the last 30 years people from the IMF and the World Bank have been turning up and saying no you don't want these These are terribly old-fashioned uh they get in the way of the uh free market allocation of capital now one of the good things that happened in Canada is that it's actually one of the few advanced economies which also had loan to value uh limits through uh the conditions for the insurability of of mortgages and you do use those those tools so I think we do have to accept that there is something called the credit cycle which we have to manage and we have to focus not on just the obje of inflation nor on just the instrument of the interest rate both in terms of objectives and tools we need a far wider Focus I think one of questions is how do you put this in a macroeconomic context and so if you come to a view that there's excessive you know debt creation going on in society the natural as an economist your first reaction is well change the price and you know if you change the price you'll slow down that and yet you have every time you go to governments and even in terms of the macroed I mean we fought you know we argued against the government that we didn't want the amortization schedule the government wanted on mortgages we want to shorten it you wanted to shorten it because we we wanted to slow down the housing market and that was an entirely uncontroversial stance that we took uh and the government's constant every time we go and say you should tighten the rules one more Notch here because I think as long as we're at this kind of interest rates we're going to have to just keep tightening the mortgage rules because that's the only thing that leans against it well I think the difficulty is that we can't just rely on interest rates and I think the core of you can't rely on interest rates is the heterogeneity of the elasticity of response to interest rates in different segments of the economy that whereas vixel argued that there was one natural rate of interest seen from the point of view of the borrower there are multiple different rates of Interest what I mean by that is if we've got a real estate boom going on and either commercial real estate borrowers or residential borrowers have got it into their mind that real estate prices are going to go up by 10% varying the rate of interest by a half percent ain't going to slow that down you've got to use quantitative levers yeah and can I just say one one thing and then I got to say something because we're starting to get over it I'm going to ignore that stupid clock because uh they didn't put it on soon enough please wrap up for I can't speak English yes go ahead okay just a little point that it's not only the elasticity point that dare point out it's also that there are large macroeconomic externalities that uh when there's a credit bubble we all suffer and that those credit bubbles tend to be focused on fixed assets like housing real estate and because that is the case we have to directly uh address uh policy levers that can actually get at that and that won't be through a single instrument like the interest rate but but I think can I just do one more microphone yeah and that is I never get a loan from the TV bank go ahead yeah yeah but managing this rotation of the source of growth is hard to do and every time you go to governments they say yeah I agree with you in principle but not right now and that's what perpetuates these things because they're worried about short-term growth themselves all right I am supposed to wrap up we didn't get to the floor um it's not your fault it is that this thing didn't go on and tell us how we were doing um one thing about being a politician is you blame somebody else but the um I'm G by means of wrap-up I'm gon to I want to ask you a question the fact of the matter is that if a man from Mars was listening to this conversation you're all saying what we should do and he would feel very confident that in fact we are going to Sol solve the problems that occurred out of the out of subprime the subprime crisis we're going to solve all of these problems that led to the 2008 recession on the other hand if you look at what's happening as opposed to what we're saying too big to fail is the fact is too big to fail is now worse than it was before there is no treaty uh for the uh for uh the financial stability board that gives us the ability to sanction there's very little coordination between the countries and for God's sake we now have switched from subprime in houses to subprime in cars so tell me something despite everything that's been said up here are we making progress uh if I to start off I I think absolutely so I think you exaggerate uh and uh I think you know for the institutions that are regulated I mean today we are holding twice the capital that we were holding before and we were unaffected by the crisis and so I think across the board banks are holding more liquidity and more capital I think we are creating a non-bank sector and I think we didn't get into that but as you tighten down the regulation of the banking sector those smart people go out of the banking sector and into the non-banking sector so you have but I don't I think we've made progress it's just this is we're in a macroeconomic environment that creates an enormous dilemma we're addicted to leverage in society and yet we seem to need leverage to keep the economy going all right you want to tell them that I haven't exaggerated it you want to defend go ahead Joe well I I think proverbial half full half empty I think we have made some progress uh I think that everybody understands the politics particularly in a country like the United States where money plays such an important role in politics and there's so much money in the rank that the financial sector has and has a strong incentive to try to maintain those ranks uh I think it's very clear that we haven't done as much as we should have uh what perhaps disturbs me the most though goes back to uh what Adair said uh there are some fundamental reasons that we've had this credit growth and uh because we don't haven't fixed the fundamental reings politicians are always under the pressure to keep the economy of Full Employment and if the only way you can keep the economy of Full Employment is keep the interest rate low and uh deregulate and you know hope that the bubble breaks after you leave office rather than before and Bush you know had the bad luck that it broke before he left office uh the the fact is that that uh policy makers and government are going to have an incentive to create a credit bubble so to me the fundamental issue is to go back to the question why is it that we need we've relied so much on this credit creation to keep our economy at full employment it's good that we've kept tried to keep it at full employment but it's bad that that we haven't gotten gotten to the underlying problems and that's really where I hope you know next time we can focus uh some of the discussion of what are the underlying problems that have led the us to have to rely on this this credit expansion D than I actually we made this amount of progress I don't know whether you can see this glass is a quarter full but 3/4 empty I agree entirely with Ed we've made quite a lot of progress on the specific thing of making the financial system itself more resilient so I think the probability of failure of major Banks because of what we've done on Basel 3 on capital is much less than before but we have not dealt with the fundamental underlying problem of why is growth so credit intensive and until we deal with that we may end up piling up problems in another fashion perhaps 10 or 15 years hence thanks excellent uh on the too big to fail problem which I think is not being addressed anywhere uh what we should try to do is to find uh a provision that introduces a dis economy of scal in banking uh and uh liability Provisions for Bankers is one way of doing it uh that is if there we had this clawback uh uh Provisions for individual Bankers uh you would create a system where uh people in one Department of a big bank would suddenly have an intense interest in what is being done in other Departments of the bank and in and you have the potential for creating essentially internal conflicts in the banks about uh policies being pursued which in turn could lead to them shedding some departments and so on and uh that's the only uh this economy of scale that I have uh seen mention thank you uh we're going to go to the floor Jim thank you uh outstanding panel I have a question for Ed um and there's been a fair bit of comments by uh uh Axel and Joseph about liability and claing back and individual behavior and incentives and and I was a bit surprised that I didn't hear the word board of directors brought up in the in this panel um and specifically on the principal's base versus the rules-based and and this is for Ed you've sat in several dozen audit and risk committee uh meetings in your career can you tell me about the the liability elements of how the audit and risk committee functions in a principal based because I understand they have some aspects of personal liability and and that's where it plays and that's where the rubber meets a road and does that go to system design or don't I understand it right sure if I can just pick up I completely agree on the compensation so one of the things that we have in our place is that I have to when I retire Hold My Equity in the bank for two years so I can't take my money and run uh I've deferred all my cash bonuses into that equity and that long-term Equity that that stays there so I think there are things where you can get a whole organization I completely agree with you where everybody basically is putting their money on the equity and they have to hold the equity for a long time so that they really do feel the pain unfortunately we saw cases where that was true and they still screwed up so it's not a perfect answer to to everything I think on the you know on the the mortgage system I think again the fact that Canadian Banks hold the mortgages on their balance sheet is an enormous factor in changing what kind of rules we push for because we end up owning that ultimate liability and so I think this you know disintermediation that's going on in the United States where you securitize and get it off and you really only trying to decide how many seconds you have to hold it and would there blow up in those seconds that is at at the core but that's a system the US people try to find that and it embedded in having 30-year mortgages rather than shorter term mortgages it you know it's flawed um but I think you know in Canada there's still things that we could do I think to slow this down and put more Equity against houses there are things I think micro rules but in the end uh I think the banks hav encourage people the one another example would be can you walk away from your home and so we have one Province you can everywhere else you can't and so when you borrow that mortgage you're personally liable there's a number of states in the United States and the ones that got in the most trouble was where the consumer could take the mortgage out and then walk away from it and I think there is ways in which you can move the system that everybody in the end owns liability for this I can't I can't see with the light my is that sunny yeah uh I'd like to question the panel's premise which seems to be that the two biggest problems are one that the biggest costs of a malfunctioning financial sector as ad there said rise because of financial instability that's one and the second that the continuous rent seeking and the relative growth of the financial sector is the other big problem I think you're missing perhaps what is the single biggest problem which is that on a day byday basis is there is very large scale misallocation of resources happening because of a financial sector with distorted incentives not all of which is going to show up as a crisis uh resource allocation difference of a net positive value real rate of return of 4% versus 3% adds up very perniciously very significantly if it's done year after year after year and it doesn't show up in a crisis because not everything goes to B and I think that is the most pernicious problem it's the hardest to catch and related to this is the point that it's not the direct allocation of financial sector that matters it's the Norms the financial sector makes we know from surveys of Chief Financial officers of the amount of forone positive Net Present Value return Investments that are foregone because of short-termism reaction of stock markets as an example and I think governments again are the other big investor react very negatively to the incentive structure the Norms set by the financial sector and it would be great to get some numbers some focus on whether this is responsible for the secular decline in macroeconomic growth rates or not go ahead well I I I think there's a lot of Truth in what you just uh said that let let me try to uh maybe just rephrase it a little bit that uh one of one of the things I mentioned very briefly is the financial sector is not been providing money to small and medium-sized Enterprises which can be an important part of the growth of any economy they've been focused more on on the one hand uh speculation and on the other you know writing cdss and things like that and uh uh and on on on the other hand recycling money to Consumers and any viable economy has to get money into creating new jobs and so that the incentive structure in the banking system is such that that's a lower profitability and higher risk and they haven't been doing it uh so that's an example I think of the kind of misallocation of resources year after year which adds up to a less Dynamic uh vibrant uh economy interestingly another aspect of this is um that that uh on average and you know the the data that Ed talked about of bringing uh uh wealth management fees down is is very positive that's at the the positive end the average though they've been very good the financial sector at what say what George A A office referred to as fishing for fools they've been very successful in finding lots of people who don't understand that you can get a wealth management services for nine basis points and they've been able to find lots of people who can pay 1% 100 basis points and uh that means that if you think about it and there have been some interesting studies in the UK when they went from public to private pension part of the social insurance system the amount that a retiree gets is reduced by about 40% from what it would have been had they done it in the public sect sector uh now you got to believe that that's a big wag we're not talking about 1% we're talking about 40% lower retirement income that's big so I think that there that that this kind of constant nickeling and diming that I described you know that was the really brilliant thing about say charging uh The Interchange fees and the credit cards nobody noticed it it was just a few pennies here and there but adding up you're talking about billions and billions year after year it really distorts our economy thank thank you I I the time regulator set a very very strict time limit on us and I think that it is really it it it really is very symbolic of the issues that we are talking about that we have broken every principle set by the time Regulators so thank you all very very much and thank you time well what

Channel: New Economic Thinking

Views: 28,264

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Id: 09tMZRy7pIs

Length: 100min 51sec (6051 seconds)

Published: Sat Apr 12 2014