The financial crisis of 2008 is a looming figure in current economic thinking. The global economy is still slowly recovering from the shock, and policymakers and academics continue to discuss the structural changes needed to prevent a recurrence. The stress of the last half decade has made two things very clear: A productive and innovative financial system is essential to the broader economy, but financial innovations made irresponsibly—without consideration of systemic risk and other impacts on society—can wreak havoc.
A plenary session at “Business + Society: Leadership in an Increasingly Complex World,” the conference marking the opening of Edward P. Evans Hall, will take a broad look at financial institutions and markets and their role in helping people throughout society improve their lives. The panelists are academic leaders and active investment managers: Robert J. Shiller, Nobel Prize winner and Sterling Professor of Economics at Yale; David Swensen, Yale's chief investment officer; Zhiwu Chen, professor of finance at the Yale School of Management; and Jane Mendillo '84, president and CEO of the Harvard Management Company, which manages Harvard's endowment. The panel will be moderated by William N. Goetzmann '86, Edwin J. Beinecke Professor of Finance and Management and director of the International Center for Finance at Yale SOM.
In advance of the live event, the five discussants gathered for a preliminary conversation in which they discussed the role of finance in society, how and why the industry can malfunction, the benefits and drawbacks of innovation in financial markets, and how best to teach finance. Below is an abridged version of their conversation. Read the full transcript on the conference website.
You can also view a live broadcast of this discussion and all of the other panels at the Business + Society conference. Find the schedule on the conference website.
William Goetzmann: I thought this would be a great opportunity to get you together to talk about what finance can do for society, what it has done, what it should be doing more broadly.
I'll start with Bob, since you've written a book about finance and society.
Robert Shiller: Finance is about creating the wherewithal for human activities. I teach introductory finance. I like to ask my students what kinds of worthwhile human endeavors there are, and whether they can think of any endeavor that they can do alone as an individual, without an organization and without resources.
The students find it very difficult to think of anything they can do like that. We're interconnected. Every valuable activity is interconnected. One student suggested I could be a poet, and I don't need financing to be a poet. I can compose poems in my head and memorize them, like Homer did. But I replied, that's not a productive activity. Poets need places where they can read their poetry. They need audiences, theaters, or venues for poetry reading. They need publishers. They need printers. They need bookstores in order to make it an event, to make it something worthwhile.
We are a financial society. Just about anything important that happens is financed, and it involves people who are trained in finance.
One of our duties as educators is to reinforce people's understandings of things that are almost obvious, but in fact are often forgotten. And when people view the financial community, it's often with hostility. And I think that it's part of our role as educators to bring back to their consciousness a sense of the legitimate and very important role that they play.
David Swensen: Let me pick up on Bob's comment that there's a tendency to think of finance as a less-than-noble profession. It shouldn't be that way, but I'm afraid the financial services industry has lost its way. If you look at what's happened during my more-than-30-year professional career, finance moved from a profession where fiduciary responsibility mattered to one where only making money matters.
Thirty years ago when I worked at Lehman Brothers, the SEC had just introduced shelf registration of securities. There was this big debate at the Lehman Brothers commitments committee about whether or not the firm would underwrite bonds that were issued by a Fortune 500 company with which the firm had no prior relationship.
Lehman was worried about its reputation. I thought, this is a great debate. It's a very healthy debate, because the firm is really concerned about its reputation.
Fast forward to the recent financial crisis. It is absolutely clear that the participants in the financial services industry didn't care one whit about what they did, as long as it was profitable. They engaged in all sorts of activities that were detrimental to society at large, knowingly participated in these activities, just so they could make money. Any tension between fiduciary responsibility and the profit motive just disappeared.
Goetzmann: Do you think that's a solvable problem?
Swensen: Well, it's solvable if you have the right people engaged in the activity, and it's solvable if you've got the right regulatory environment.
Goetzmann: I think just teaching people what it means to be a fiduciary is valuable. Fiduciary responsibility is a simple thing, but it creates a sound foundation for thinking and decision making. It cuts through a lot. It helps solve a lot of problems.
Zhiwu, you've been working on educating China about the benefits of finance, and really thinking about the role of finance in society.
Zhiwu Chen: I have focused on individual freedom as a topic. In America, we take individual freedom as a given. But in the China context, while individual freedom has been on the rise, there is still a long way to go. Then, what roles does financial development play in facilitating the rise of individual freedom? I was then reminded of overlapping-generational economics models in which parents save and invest in children with the expectation that when their children grow up, they can live on the children’s payback.
In traditional societies, individuals were not so free, not because they did not want freedom, but because in the absence of explicit financial markets, they had to rely on human beings or children as the embodied financial instruments. Children were the stocks, bonds, insurance, and all kinds of financial instruments of yesteryears.
It took the development of external financial markets such as insurance, retirement funds, annuity contracts, mutual funds, and so on to liberate the individual. Once risk-trading and intertemporal resource exchanges are done through explicit contracts and in the marketplace away from the family, all these old cultural norms constraining individual freedom are no longer needed.
My research shows a strong connection between the rise of modern finance and the rise of the individual. In this sense, Wall Street should feel good, as they are partly responsible for the rise of individual freedom in the U.S. and beyond.
Goetzmann: Jane, when I think about your job, you took on one of the biggest tasks in finance, which is managing the endowment of the oldest corporation in the United States, and also one of our great educational institutions. By its very nature it is benefiting society directly. I've heard you talk pessimistically about the future of finance, of expected investment returns, and whether or not endowments really have the capability of supporting all the great things that their institutions want to do.
Mendillo: In respect to your first question, about whether financial markets are a force for good or evil in society, I would be very firmly on the side of good versus evil. Financial markets are clearly needed, and serve an important purpose, ensuring that capital will flow to places it is needed and where the rewards for investors and the risk seems to be in synch.
From time to time, the financial markets lose that equilibrium—the housing bubble, the credit crisis—and the risk for the return that's offered can get way out of synch and may not be well understood.
But in a normal, functioning market, with money flowing freely through, information being fairly shared, with equity investors getting what they perceive to be adequate returns for equity-like risk, and debt investors getting what they perceive should be offered for debt-like risk, capital does flow to companies, projects, and investment opportunities, and fill gaps that need to be filled. Finance works.
Having said that I do think that there are a number of specific investment areas, asset classes, that were underpopulated with investors 10 or 20 years ago but that are much more crowded with investors today. So we as investors really have to stay on our toes and anticipate what that means for us as a large endowment, in terms of expected returns. We need to remain alert and innovative, and evolve as markets evolve. Because our institutions, a Harvard or a Yale, can be counted on to continue to want to increase their contributions to society, which inevitably means increasing their budgets, which in turn calls for even more endowment support.
Goetzmann: Perhaps an aging global population with great need can’t afford to be allocated 50% to stocks and 50% to bonds. This portfolio might not have sufficient exposure to the equity premium. We may all have to reach for more equity return. I wonder what will happen in the long run as this tendency grows. Will ingenuity and invention grow as fast as we need it to?
Shiller: We have two buy-side investment managers here. I wanted to say that finance is broader than that. We have the sell side. We have consultants. We have lawyers. We have accountants. We have to keep all of these things in mind. So what are the big issues right now? One of them is inequality, which is rising today, and which Occupy Wall Street emphasized.
But another concern right now is jobs, and President Obama is out there now talking about what to do about the problem that there are so many people who find there isn't opportunity. So our president has proposed the creation of what he calls innovation institutes. He wants there to be 45 of them scattered over the country, financed by the federal government.
I say he's getting at a core problem that animates voters and he comes around to setting up something that looks to me like an investment bank. I'm still trying to piece together why the government should be doing this, but maybe there is a role for government. But it gets back to the fundamental idea—I think you were saying, David—that we have to integrate our whole concept of the structure of our financial institutions with our missions for all of society. In a sense, maybe they're not tuned right now, and maybe there can be retuning of these institutions, so that we can move ahead to something different.
Swensen: Or maybe we don't need to move ahead to something different. Maybe we need to move back to where we were in the past. The basics of what we need in the financial system are pretty simple. I would like to see a return to the separation of commercial banking and investment banking.
I’ll bet that you’ve all seen the movie It’s a Wonderful Life. Well, that's what our banking system should be like. It should be Bailey Brothers Savings and Loan, where George Bailey knew his borrowers and he knew his depositors. It was a simple gathering of deposits and making of loans that stayed on the balance sheet. These basic banking activities benefit society.
Today, there are all sorts of ancillary activities that the financial services industry has embraced. By and large, the activities provide little benefit to society. Often, the most profitable activities are those that are opaque and those that are complex. And then to that bankers add excessive amounts of leverage, which creates an incredibly volatile mix that ultimately led to the financial crisis.
The non-core activities, the opacity, the excessive leverage all stem from greed on Wall Street. An added consequence of this complex, opaque, highly leveraged financial system is the inequality in income and wealth that is tearing at the fabric of our society. The problem with inequality actually starts with financial services, because that's where this increase in compensation relative to the rest of the economy has been most pronounced. If we can address the issue of compensation in financial services, we’ll be well on our way to a solution to the problem.
Chen: Finance as an enabler of equality has been much less understood. Usually we don't teach this in the courses. But over the years, especially when I looked at the history of consumer finance in America, I was really intrigued by the first adoption of installment payment loans used to promote sewing machine sales, because in the beginning, in the 1850s, just as the Industrial Revolution was finally starting to have an impact on the American home—what goes into the living room, the family room, and so on—the sewing machine was one of the first to go in but it was too expensive for middle- and low-income families.
Around 1854, Singer and Co. introduced this “Buy Now—Pay Later” installment loan. This financial innovation right away allowed lower-income families to enjoy sewing machines.
When you think about it from this perspective, certain financial products are particularly important for low to mid-income families, because these financial innovations help them smooth their lifetime income so that they don’t have to wait until they are old to buy a home, their children can enjoy more equal opportunities.
Goetzmann: Bob, you have been for a long time thinking about financial innovation as a way to solve problems, and Dave, I hear you saying we've had too much financial innovation, and complexity has not been helping us, it's been hurting us.
Swensen: I'm not against financial innovation. When I was on Wall Street, I was involved in structuring the first swap transaction between IBM and the World Bank. That was a good thing. But the regulatory environment needs to keep pace with innovation.
Consider the case of swaps. Let's force swap activity onto exchanges, where it can be transparent and where it can be reasonably regulated. Exchange trading of swaps would have made a huge difference during the financial crisis. AIG had all these swap positions that were on one side of the market. Neither the market participants nor the regulators had any idea that these massive positions existed.
Mendillo: I think teaching finance should also include teaching innovation. In fact, as a student of finance you should be exposed to three stages: the basics of finance, innovation in finance, and the responsibility that financial managers have to their clients and institutions. Because you absolutely can't do a decent job of financial or investment management without knowing and having really solid basics. And then innovation and the ongoing need for innovation in financial markets, and the good and bad that can come from innovation, as we've been discussing today, needs to be understood. And finally, there is to me this really overriding thing of responsibility, which goes to the moral compass. We need to address these high level issues as well if we're going to train our students to be leaders in finance, and to take on roles where they're dealing with a lot of money, especially other people’s or institutions’ money.