What’s Good for Finance Is What’s Good for the Country. Right?

Question: Do you believe that what’s good for finance is what’s good for the country?

Chrystia Freeland: I think that it's important to be a little bit more specific in terms of what we mean when we're talking about finance.  Finance is a really big area.  There are a lot of people who work in finance, there are lots of different companies who work in finance, and the interests of every single financial services firm are not perfectly aligned, nor are the interests of the people working within a single financial service firm perfectly aligned, nor, as we have discovered with this crisis, are the interests of management and shareholders always perfectly aligned.  So, I think there are lots of very different interests involved. 

Having said that, I think that what we have seen in the past decade or so is a real growth of the financial services industry as a proportion of the economy and I think with hindsight, it's probably fair to say that it's not that safe and not that stable for the national economy to have finance be quite that big.  I think though, one of the things that it's easy to forget in the cry over the crisis is one of the things it did teach us is, how essential financial services are to the economy.  The reason for that $700 billion bailout was because the rest of the economy would not have survived.  We would have all gone down with Wall Street. 

So, I think we are in this paradoxical moment where we've now understood collectively more than ever how essential financial services are to the healthy running of everything else.  But at the same time, I think there is a dawning understanding that maybe having an economy which is over reliant on financial services is not that terrific.  And I do think that there is another really contentious issue at the moment, which is to what extent is the collective good served by really, really high profits being made by financial services firms and by people working in financial services firms?  And I think it is obvious why that should be such a politically contentious point right now because taxpayers, who in America, are suffering from 10% unemployment, realize that they rescued Wall Street with their money, they're maybe unemployed or certainly afraid of becoming unemployed and yet they are seeing the return of really hefty salaries and bonuses on Wall Street.  So, there sort of feels like there's a certain cognitive dissonance there. 

I think the best way to think about those questions though is not through the prism of compensation, but through the prism of what does the system need?  What benefits the system overall, and also, through the prism of, who now benefits from an implicit, or even explicit state guarantee.  And I think that we need to be thoughtful about those firms, those parts of the business which now effectively have a taxpayer insurance policy, because that's what happened in the fall of 2008.  And I think it is quite legitimate and indeed essential for governments and regulators to step in and say, "Okay, you are too big to fail, you're lucky in a way that you are too big to fail because it meant that we bailed you out, but what that means is, in the future, we have to rein in your activities in some lengths to at least minimize the possibility that this happens again."  Even as thoughtful legislators, thoughtful regulators, thoughtful economists go through that sort of a process, I think that it is important also to bear in mind that even in that kind of a more rigorous analysis, you could have players on the outside who explicitly do not benefit from a government guarantee.  And who therefore are free to take on the riskiest possible bets, free potentially to make the greatest possible returns, but also free to go broke. 

And one of the really interesting stories in this whole crisis is the dog that didn't bark as it were; which is the hedge fund industry.  I would say, ahead of the crisis, a lot of the Cassandra voices were talking about how hedge funds were posing a huge systemic risk to the economy, to the financial system.  And that wasn't a crazy thing to say.  In fact, we had seen the example of the LTCM in the 1990's.  As it turned out, hedge funds did not pose a tremendous systemic risk.  And what we saw was a really healthy operations of market mechanisms where a lot of hedge funds went broke, a very few made a great deal of money and industry is now coming back. 

Question: Why do you think we should or should not let big banks fail?

Chrystia Freeland: The question of whether banks should be allowed to fail or not, really ultimately has to be about is this bank too big, or too connected to be allowed to fail.  And regulators need to be very, very thoughtful at that moment of crisis about, if we let this institution go will everybody else suffer, or will it just be the institution that suffers? 

For markets to function properly, we should allow institutions to fail and we should be certain that the shareholders and the bondholders and the employees in those institutions that fail suffer.  That's how a market economy works.  People who make the right decisions prosper, but to enforce that discipline you have to make the people who make the wrong decisions go out of business. 

What was really problematic about this crisis was we collectively were not in a situation where that could be allowed to happen and collectively it became apparent as the crisis went on, and we do need to remember that Lehman was allowed to fail with really painful and instant implications.  So, at that moment, and it really was a post-Lehman moment, there was a belief, which I think was right, that you couldn't let the whole system fail. 

The consequences of that should be that regulators and lawmakers act now, in this lull after the storm, to limit the number of institutions and the size of institutions which are too big to fail.  And if there is a decision, which may be the case, that's it’s good to have really big banks that a national economy or a global economy is best served by the existence of big universal banks.  I think that's a legitimate outcome, but those banks then need to be subject to much stricter regulation than before so that it's much less likely that they should fail.  I think the right outcome is going to be some sort of a greater move towards intellectually separating the utility function of the banking industry from the casino function and we do need banks to perform the utility function.  Those banks should be really, really strictly regulated and very careful thoughtful policies should be in placed about how to handle the failure of those banks as we have in the example of the FDIC and the way it regulates and resolves the failures of commercial lending banks. 

On the other side of the divide, we should allow the continued existence of speculators.  I don't think speculation is a dirty word.  I think speculation is a really essential part of capitalism.  But we need to be sure that speculation, the casino function of finance, exists in a space where, if it fails because speculation by nature will fail a lot, it doesn't imperil the collective.

Recorded on December 10, 2009

Secretary of Defense nominee Charlie Wilson famously remarked in his 1953 confirmation hearing that he couldn't imagine something in GM's interests that ran contrary to the interests of the country. Chrystia Freeland, the Financial Times’ U.S. Managing Editor, answers the question as it relates to finance.

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