WASHINGTON & WALL STREET – APRIL 24, 2012 (LAST CLASS)

[NOTE: This is a verbatim text and contains many gaps.]

I want to make a few comments by way of ending the class. I want to just talk a

little bit about what we covered during the semester. Let me make a few observations

about what I think are the mega forces that we’re really talking about. When you think

about this class, what makes it so valuable is not the precise issues relating to Wall

Street and Washington, but what the Wall Street-Washington that nexus represents.

What it reflects and how to think about it in terms that make the ideas applicable in lots

of other important issues.

I’d like to just express a few very short views about some policy imperatives.

Steve and I share a certain humility that every one of the issues that we talked about is

deeply complex. There isn’t a simple one there, and there isn’t a simple answer. And so

it’s never been our intention to say, this is the right answer. But because it’s the last

class, I’d just like to toss off a few ideas, none of which may be surprising, but I’ll feel

better just letting you know what I think. And then there are a couple of issues that we

don’t have the answer to – I certainly don’t have the answer to – but I will signal them

as being really big issues that are intractable and that are worth thinking about and are

worth exploring in one capacity or another as you graduate.

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What We Covered

We really covered a lot – including the history of the Wall Street-Washington

relationship, the 2007-2009 financial crisis, the regulatory response, the international

financial system, leadership, macroeconomic issues and public policy. That’s a lot for

one semester. And in some ways, it’s too much, but I don’t think we could cut off any

one of those and not have given a rather comprehensive contour of what the subject is

about. And we certainly interacted with a lot of people in two trips to New York, and

five days in Washington. And I heard through the back door that some of you thought

there were too many meetings. So Steve and I have decided next year to double the

meetings. But those two trips were really designed to bring us into contact with quite a

variety of people – both in the private sector and public sector – a wide range of

responsibilities. And I think most important, a wide range of personalities. Whenever

you think about some big subjects like Washington and Wall Street, those are

abstractions. But when you meet the people and see people who are working together,

that their backgrounds are different and their personalities are different, it gives you a

real sense about whose making decisions and it gives you a way to interpret how the

decisions that continually emerge.

We had a number of really good student presentations. Steve and I are always of

two minds about these presentations because if they don’t go well, we’re wasting a lot

of students’ time. On the other hand, it’s really good practice for you and for a

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management school there’s probably no skill that is more important than the ability to

get up and deliver a message on a complex subject. And it’s fair to say that virtually all

of you really rose to the occasion. I sat here and I learned a tremendous amount from

these presentations. And we owe you some gratitude for the teaching that you did.

You made some really important points on obviously some really important issues.

We explored a lot of philosophical questions. And I say philosophical because in

the end there may be no answer. But these are concepts that are actually crucial. And

an ability just to be able to talk about them and in my way of thinking, most

importantly, talk about both sides. To be able to interpret why various decisions might

be made – this is really important stuff and I think as I was putting together this list, I

was thinking what haven’t we mentioned that’s really central. And I don’t think there

are too many, at the end there were a few issues that I wish we could have explored

some more – particularly ethical issues – but not many.

And very importantly we talked about how Wall Street and Washington relate to

one another. We talked about it through a lot of different ways; we met a lot of people

who basically gave a view of the revolving door firsthand and through discussions about

interest rates and currencies and debts, regulation; even overseas market access where

the government and Wall Street firms team up to break into foreign markets. All of

these are ways that two worlds interact at least at some times with enormous amount

of tension and some times with enormous amount of cooperation. And one of the real

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interesting things is that even at the height of the crisis, no one could possibly have said

that the links between Washington and Wall Street had broken down. There was a lot

of bad public relations; the President of the United States saying bad words about the

bankers, bankers walking out of meetings; but underneath all the pyrotechnics, the

show went on. And the markets and regulators, the markets and government, were

stuck together because they both need one another.

Sizing the Problem

So let me make a few personal observations and I think the biggest one here

relates to my obsession with how to look at any kind of issue or how to look at any kind

of problem and that is how do you draw a box around it? How big is that problem? To

me, that is a really important issue. I’m not sure I do it well, but I think it’s absolutely

crucial, because if you draw the box too small, you can miss the point altogether. You

wouldn’t know, for example, how much resources you need to bring to bear on a

problem. But if you draw the box too big, you could be totally lost and you could be

finding yourself connecting dots that don’t need to be connected, but that take you into

a wasteland. I am always guilty of drawing the box a little bit too big. And I want to talk

a little bit about the box that I see when I hear Wall Street and Washington, because it’s

a box of a number of real metaphors. I don’t think we can talk about this relationship

without understanding a bunch of other phenomenon. For example, I don’t think you

can understand the interaction of Wall Street and Washington without really thinking

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hard about globalization and what it is and what it’s doing and where it’s standing today

and where it might be headed. I don’t think you can understand this relationship

without really thinking hard about technology and how the change in technology has

really influenced markets and influenced the way governments relate to markets.

This third thing is really important and I wish I could explain it better. But when

we talk about the markets today, we’re really talking about large scale complex systems.

And I put it that way, because these kind of complex systems occur outside of markets.

The weather is one of these systems. Supply chains that industrial companies use that

span the world are really complex large scale systems. When the Japanese nuclear plant

had a meltdown, it just didn’t happen because it was a lousy plant. That was a result of

an earthquake, a tsunami, and then a failure of the system. One system. All of you who

study climate change understand what large scale complex systems are. And the

financial system has become that. And the result is that nobody can possibly

understand exactly how it works. We can’t understand all of the interconnections. We

can’t understand where all the vulnerabilities are; we can try – we have to try – but the

interaction of globalization and technology and human error and systems within

systems, this is really at the heart of what Wall Street and Washington is wrestling

about.

The tension between centralization and decentralization is one of the major

tensions of our times. Forget about Wall Street and Washington. Every single

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government faces this dilemma. Every type of governance issue ultimately boils down

to how tight or how loose and when you overlay this on complex large scale systems,

you realize that you’re dealing with something that may very well outstrip the XXXX of

control.

There are other mega forces and I won’t go into all of them, but what Steve was

talking about – indebtedness and deleveraging – we may not be able to say whether this

is going to leave to a crisis, but you can take it to the bank that for the next ten years,

this is going to characterize the world. And nothing could be more central to the Wall

Street Washington nexus than this phenomenon that five years ago, three years ago,

when we started this course, that wasn’t even… it very well could have been that the

momentum for deleveraging was on the rise, but not to the extent that it rose as a

result of the financial crisis. Steve showed the graph on financial services – we’re

dealing here with a very complicated industry which independently of a particular crisis

is undergoing all of the changes and all of the rhythms of the modern world that is being

buffeted by all of the shifts that Steve talked about – global imbalances, the skills that

people have, the various needs that finance must provide. We’re talking about here

inconclusive debates about some of the most basic XXX – austerity vs. growth at the

heart of everything that’s going on in Europe and potentially at the heart of the next

crisis that will envelop us. We’re talking about issues like financial stability vs. creative

destruction. How much stability? And at what cost? What have we gained from

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substantial innovation or from the ability of companies that fail and regenerate? At the

heart of everything that we western economists believe, where is this XXX at the heart

of everything that we talked about? Or how big is too big? We talked about too big to

fail, too complex to manage. How big? In a world with a growing population and with

massive resource needs, how big is too big? And finally, I say finally, but I’m sure there

are many other mega forces, but ultimately the show has to go on. The need for finance,

to develop the resources in the world, to finance hyper urbanization, to deal with all the

needs of the rising middleclass; whatever happens – we talked about Wall Street and

Washington – whether there’s tension or not, but one way or another the money has to

be put to use in order for economic development, crucial economic development.

And finally I think we’re dealing with public opinion. And this is also very xxxx

because there is a growing resentment about financiers, the rising income inequalities

of the XXXX the very strong political stand. And so this is a mega force, where don’t

know where it’s going, but unless history is going to be repealed, we could very well end

the financial world and the regulators could be in for a very serious political reaction

down the road.

So let me give you a few of the things that I think are going to be really important

in terms of policy XXXXX. The first is I’m very sensitive to all of the dilemmas concerning

the idea too big or too complex to fail. I’ve come around by thinking about this over the

last two years in this course, that the right policy prescription is to break up a huge

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concentration XXX. I know that it’s not easy and I know there are a huge number of

issues, huge number of questions that have to be raised; but relative to the alternative,

relative to the concentration that is growing and is likely to grow, I think that there has

to be some way to bring national institutions to a size in which the damage that any one

can do is vastly reduced. Without that I think we lose all the value of competition;

without that I think moral hazard is a joke; without that all the stuff about resolution

authority is really in a realm of XXX, there’s no possibility that any of these big

institutions XXX. And right now there’s a massive amount of effort going into defining

how big is too big. I would rather the effort be the other way and just settle in, make it

much, much smaller than it is. You know, big institutions are slimmed down all the

time; parts are sold off, XXXX feasible and XXXX. There is no possibility of that

happening.

I think on capital requirements it is the wrong policy to try to parse capital for

every conceivable risk that you can imagine. And basically to allow financial institutions

to help to define how much capital for whatever risk. I go for something much simpler,

much tougher, call leverage is leverage. Take a lot of the risk adjustment out because

ultimately I think this is the most powerful tool. And without excessive leverage, the

chances are further XXX.

When it comes to regulations we’re missing something and I think it was Bob

Rubin who mentioned this – we don’t have a mechanism for cost-benefit. Now none of

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this stuff is XXX but we can’t continue to build regulation on regulation without having

some independent source at least providing credible analysis of what the costs are going

to be. We can debate the analysis, but there has to be something XXX to the way that

the congressional budget office which is not infallible, advances analysis and various

budget moves [??] XXX.

Volcker Rule is a mess. It either has to be started again or it has to be XXX.

Continue rolling on with it as it is, we’ll have another movie… if it wasn’t quite so

technical, it would be great on Saturday Night Live, because it’s XXX bigger and bigger

and bigger, even to the point where the guy who invented it is embarrassed about what

it’s become XXXXXX.

On derivatives, I err on the side of transparency. I know that financial institutions

are very concerned that there’s a lot of hedging, a lot of derivatives that are used in the

course of normal business; I just think that this is XXXXXXXXXXXXXXXX and the notion of

all of these exceptions creates a piece of Swiss cheese. And like breaking up the banks,

there’s no possibility that what I’m saying is going to happen, XXX.

These last two are pretty tough. I’m really concerned that after this crisis, so few

senior people have been punished. On the other hand, I think it is a fair judgment that

most of them might have been derelict – they weren’t criminals. But the one thing that

I would like to see is that they lose their job. Regardless of their motive, that if an

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institution fails, the top management should be removed. If an institution fails in such a

way that it needs a government bailout. And likewise with the regulators; I don’t think

any regulators have been punished. And maybe you can’t punish them legally, but

certainly the ranks of the regulators should be XXX. Without some minimal

accountability, we’re losing the human element that I think is absolutely crucial and that

is that if they make a mistake, even in good faith, there is no consequence. Now I know

there’s consequence in the sense that they lose a lot of their money, their net worth

and that kind of thing. But in my view that’s not enough. There has to be a

consequence that the public actually sees and feels it was a good XXX and now this

would probably reduce a lot of risk taking and I could make the case that that would

reduce some risk innovation, but all things considered there’s a bigger societal issue.

And you have to pay the consequence for a failure that has enormous collateral

damage.

Here are some of the issues that I would like to explore. I think they’re very, very

difficult, but I’m only going to take two here, but the ethical issues. These are really

tough. This is really tough because you know everyone here knows one something is

black and white, that’s not XXX, but when it’s very gray and very fast-moving, and there

is a chorus of support inside the government and out and you’re doing something

wrong, where that line is drawn, in fact what the framework is for even thinking about

it, kind of eludes the XXX. I spent 14 years on Wall Street, less than half of what Steve

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did, and I was involved in a couple of ethical issues, a different time, but there was one

time when I was very heavily involved in helping developing countries restructure their

XXX and Lehman Bros. had a leading position in this business and XXX and we were

winning a lot of mandates and then the government XXX. It was a huge contract and I

went to my boss and said, “I don’t think we can do this.” And he looked at me like I was

crazy, and I said, “We’re going to be paid with drug money.” And he said, “How do you

know?” And I said I was looking at the balance of payments and 80% of their export XX

are basically narcotics. He said well what about the other 20%? XXXX and I said it’s just

not right. And he said well somebody is going to do it, and he pointed at another firm,

Morgan Gredfeldt [?] that doesn’t exist anymore, it was a British firm and XXX and they

were getting a lot of mandates too. He said if they get this, then we’re no longer XXX.

And I said, well I just think there has to be a line. And he said I just didn’t understand

how the business worked and he walked away. And I figured I know now, I know how to

do this, I went to the number two guy in the firm, a fellow named George Ball, and you

guys wouldn’t know, but he had been a very distinguished American XX, one of the most

distinguished American XXX since the post WWII. He was the number two guy at

Lehman and I knew that I went to him he would call it off. And I was explaining it to him

and he said, “You just don’t understand how it works.” And I was so shattered because

this was one of the reasons I went there; he was a very principled guy, and a very well-

thought of XXXX and he sat down with me for an hour trying to explain what

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competition was like and why I was drawing such a fine line and I came away from the

experience feeling that there’s a whole different world when you’re dealing with such a

hypercompetitive arena and so much money is involved. I refused to … I said I don’t

want to work on XXX and he said well that’s your XXX, and then two weeks later, XXXX

they didn’t do it. And I was trying to figure out what happened and I never actually did

and I never knew whether I had an impact or not. But this is a relatively small thing

compared to what is happening here. And even now I’m not quite sure of what the

framework… knowing what I know now how I would have handled that, a little

differently, but imagine yourself in a situation where hundreds of millions of dollars are

at stake and you try to object… I’m only mentioning this because it’s a lot more difficult

than you think.

I’d like to know, to take this middle one, exactly what is going to be the impact of

rising level of government debt on the Wall Street Washington nexus. I know there’s

going to be a big impact. I know that in Europe in that situation with the Spains and the

Portugals and Italy – the banks of those countries have been made liquid by the

European Central Bank and with that money, he’s saying XXX so you have enough in

which anything happens to that national debt, those banks come and yet it’s the banks

that are holding up, it’s the central bank and the banks are holding up the governments

who are holding up the banks. So you have a real nexus. And I’m very curious as to how

this is going to play out over there and in the US. And every time I start to think about it

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I get a headache. I just don’t know where it’s going to go, but I think it is an enormous

XXX.

And I’m very interested in trying to figure out whether there’s any future for

global regulation and if so, what it is because I started out by saying one of the mega

forces is globalization, but there’s another force going on here and it could be

deglobalization, at least in finance. Very interesting couple of articles in the latest

Economist, talking about the retreating of many banks to their national XXX; maybe

that’s temporary, but it doesn’t look that way because the combination of regulation

and risk, over-leveraging is really taking over.

I’d like to know whether moral hazard is actually XXX. XXXX big principles, but

unless the big banks are broken up, I don’t think that … I could name 15-20 institutions

who are not going to be allowed XXX; I don’t care what Dodd-Frank says, but one thing I

know Dodd-Frank says is that the big exception saying that whatever we say the

Treasury can do it needs to do. After Lehman Bros. we’re not going to the XXX.

I’d like to know whether systemic risk can actually be managed. A huge amount

of effort going on. Steve said we saw the person who is developing the research for the

basis of this – can we really in this era of large-scale complex systems spot systemic risk

and if we saw it what would we do XXX? I don’t know.

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And finally, I think about if I were your age, whether I would go to Wall Street. So

I put the question here, can finance be a noble profession. When I left there in 1978 I

have to tell you, I felt absolutely terrific. I thought about financing XXX, I thought about

bringing companies together to create value. I thought about public finance and I

happened to be thrown into this area of restructuring developing country debt which I

thought was of enormous redeeming value, whether it was or not, I felt that way, and I

felt the people that I was with were smart and that they had the same interests that I

did. And I would really like to think that that is still possible. I do think it’s still possible.

I think that we’re in a very, very rough spot where a couple of different XXX

understandably totally negative, but the good news here might be that a lot of the

excess is compounded and a lot of the people are just gamblers who’ve been around for

so long and that… I mentioned it, but managing wealth, managing money, holds XXX

future. Is enormously redeeming. Helping people to live longer lives and make their

savings go further, building the infrastructure for the middle ground. There’s just a

million things that revolve around finance, so I think that finance can tend to be a noble

profession and I think all the time of what would have to happen to make people feel

better? Because I think it’s very important. I believe the size of the financial sector

should be made smaller; it’s much too big. But for the last three four hundred years, it

was smaller and people did really interesting things and it served a great purpose and

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this country and any country that is highly developed never would have gotten where

they were had it not been for people who were really thinking about the best XXXX.

So I think that the force is about all of this and I’d like to think that we have used

Wall Street and Washington to open up a very big world and look at it through one

particular telescope, it’s a XXXX a really interesting telescope and you made it

interesting with your participation and questions. And just being together. So I think

with that, we should open it up… go around the room and just figure out where XXX.

You go first.

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