MIT Sloan Management Review

MIT Sloan Professor Simon Johnson gave a talk here at MIT today – with the cheery title of “The Next Financial Crisis.” Johnson, a former IMF chief economist who blogs about the economy at the Baseline Scenario website, wasn’t referring to a specific crisis he sees brewing right at the moment so much as systemic problems with the financial system that make another financial crisis, in his view, inevitable at some point. 

In particular, Johnson mentioned a recent paper by Andrew G. Haldane, Executive Director, Financial Stability, for the Bank of England. Haldane wrote about the idea of a  “doom loop” in the financial system. According to Johnson, the “doom loop” concept “is actually just another term for a cycle in which you have a boom, a bust and bailouts” — except the bailouts are done “in a sufficiently unconditional way” so that “the core structure of the financial system remains the same.”

The problem? Such a bailout may incentivize bankers to take excessive financial risks in the future. ”State support,” Haldane writes, “stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits.”    

And the risk, according to Johnston, is that a future financial crisis could lead to a second Great Depression.

Johnson’s advice? Make megabanks smaller. He drew an interesting analogy to the development of antitrust law; in 1890, Johnson said, the idea of proposing a cap on the size of private business would have seemed ”ludicrous” in mainstream thinking. But then, over the next 20 years, Johnson argued, “we learned the hard way that having massive monopolies or trusts –as they were then called — develop was bad for society.” 

Similarly, today, when it comes to the banking system, “I think we have to extend our thinking,” Johnson said.

Friday we offered selected pearls from a great conversation between banking honcho Larry Fish and MIT Sloan economist (and leading financial crisis commentator) Simon Johnson.

Now we can share full sound and video.

As noted Friday, there’s provocative matter here about what needs changing in the banking system — and what changes are likely to happen instead — as well as explorations of what caused the financial crisis and why some countries escaped its worst consequences.

But for a dive into the ethics questions we mentioned, jump to 45:20. There, Fish reads the ethics oath that some Harvard Business School students wrote and more signed, with wide publicity, this past spring. Fish’s observation? “I found it fascinating that half of the people didn’t sign it! There was a big thing about how many did. I found it far more interesting how many didn’t.”

Two of us at MIT Sloan Management Review grabbed good seats at yesterday’s MIT Sloan campus-event headliner: a downwind reflection on fallout from the financial crisis. Featured attraction: a high-level round of bank bashing, with a high-level banker on hand to help do it. OK, it wasn’t only banks that were bashed. Ungenerous attention was paid to politicians, insurance firms, mortgage companies, and the general ethical standards of business people, as well. The usual suspects, in other words.

But the hall was overstuffed because the two speakers were not usual: a candid Lawrence K. Fish, longtime (now former) Citizen’s Bank CEO, and, as his interlocutor, MIT Sloan prof Simon Johnson, the former IMF chief economist and co-founder of acclaimed global economy blog The Baseline Scenario. The conversation was part of the Dean’s Innovative Leader Series. Along with heat, it generated a fair quotient of light. Plus some activist heckling.

We’ll post an edited version of the entire chat in weeks ahead, but for now, some brief highlights:

ON “JUST HOW BAD” THE FINANCIAL CRISIS WAS:

Note, first, the past tense. “It was really bad,” said Fish, “but we’re coming out of it.” TARP has actually helped, and the government will end up ahead, he said. “The returns will probably mean that the government will make money.”

Will a crisis happen again? “Yes.”

ON REGULATORY REFORM (OR NON-):

“I’m worried we’ll overreact,” Fish said. “We need better regulation, not more regulation.” Two big risks: “One, competitiveness globally [of the U.S. financial services industry]; and two, we may protect consumers so well that consumers can’t borrow.”

Johnson argued for aggressive reforms (see his blog), but Fish thinks that’s a nonstarter. “Profound regulatory reform—of the kind Simon is talking about—is probably a political unreality” because the financial services lobbies are too good and donate too much money to be countered.

ON ETHICS, LACK OF:

“There are no B-pluses in ethics, it’s pass/fail,” said Fish. And it’s not hard to assess the grade. “You know what’s right. You know.”

He added for illustration: “It makes me crazy that someone gets a $100 million bonus.” (He mentioned, more than once during the hour, the “platinum trader” who gets a bonus that’s 50% of the $200 million in trading revenues he or she generates.) “Who needs that much?” he said, rhetorically—begging the question of just how much is the right reward in a market economy where incentives are created to produce outcomes.

If not $100 million, then what should be the reward for producing $200 million in trading revenues? Fifty million? One million? Five thousand dollars and a good steak?

We joke, but not entirely. We can all decry the “obscene” bonus (though some wouldn’t), but naming the “right” amount is less easy. Where’s the line?

We’ll ask Fish, and get back to you. And, if you want more Fish while you’re waiting, see his MIT World talk.

One conundrum for scholars of innovation has been what to make of the role of financial innovation in precipitating the financial crisis. In a new BusinessWeek.com column, Vijay Govindarajan and Chris Trimble, both of the Tuck School of Business at Dartmouth, argue that while financial “innovation gone awry….nearly blew up the global economy,” it’s time to recognize that the problems in risk management can be fixed — and business leaders should regain optimism and move forward.  

How might the problems in risk management be addressed? Julian Birkinshaw and Huw Jenkins, both of London Business School, suggested in an article on The Financial Times website that companies need to incorporate greater personalization of risk management — with risk decisions being made at the right level in an organization, where people have both adequate insight and personal accountability. And economist Andrew W. Lo of MIT’s Sloan School of Management, in an interview in MIT Sloan Management Review, discussed the need for a new branch of accounting that measures risk.

Ready for an unsettling interpretation of the financial crisis? MIT Sloan School professor Simon Johnson’s new article in the The Atlantic is titled “The Quiet Coup.” His argument? As a former chief economist for the International Monetary Fund, Johnson observes striking similarities between the current financial crisis in the U.S. and earlier crises that affected emerging markets. One common factor, he indicates, is a too-cozy relationship between a country’s government and its business elites. Writes Johnson:

Elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.

The Role of Financial Innovation

According to Johnson, one of a number of symptoms of the financial sector’s political influence over the last decade was “an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.”  In a speech last week, Federal Reserve Chairman Ben  Bernanke  addressed the  relationship between financial innovation and consumer protection.

In his speech, Bernanke acknowledged that the last two years have shown that financial ”innovation that is inappropriately implemented can be positively harmful.” He later added that “the difficulty of managing financial innovation in the period leading up to the crisis was underestimated.”

Bernanke concluded that, rather than prevent innovation, regulators should allow “responsible innovation” that increases consumer welfare. How to do that? Bernanke suggested that regulators, in effect, weed out harmful financial innovation before it is implemented — by asking more questions upfront. (One example: ”How will the innovative product or practice perform under stressed financial conditions?” ) 

Reflecting on Bernanke’s speech, James Kwak, who blogs with Simon Johnson at The Baseline Scenario website, draws a distinction between two different types of financial innovations: those that make consumers’ lives easier — such as ATMs — and those that increase access to credit — which may or may not be beneficial, depending on the circumstances.

On the other hand, Kwak notes, many innovations — not just financial ones — have a “double-edged” quality – in that they offer both benefits and drawbacks. For example, he points out that the development of plastics has had great benefits — but has also led to problems such as “ an enormous amount of garbage that is now collecting in giant pools in the middle of our oceans.”  (For more on that topic, see MIT Sloan Management Review‘s sustainability blog.)

Andrea Ordanini takes an interesting look at “crowd funding” in the latest edition of Business Insight. What’s crowd funding? It’s the emerging practice of consumers investing small amounts of money (as little as $1) in products they fancy by musicians or fashion designers. It’s yet another form of community activity facilitated by the Internet.

However, don’t expect an explosion of consumer-funded start-up businesses. Ordanini notes that the “crowd funding” process “works best with products for which customers feel a strong personal attachment — products like music and designer goods. Without that bond, customers are unlikely to support a product beyond simply buying it.”

The term “innovation” is often viewed in a positive light. But, in an essay in the new Winter 2009 issue of the MIT Sloan Management Review, Peter Cebon of the Melbourne Business School looks at the financial crisis that occurred in the fall of 2008 as a systems accident –and, specifically, a systems accident that was fueled in part by innovations in the financial sector. Notes Cebon:

While innovation can be extraordinarily valuable, innovations, whether in genetically modified organisms or financial instruments, can contribute to systems accidents. Consequently, an innovation economy needs a strong and intelligent regulatory regime that aggressively manages systemic risks.