Introduction
Matthew Bishop is the US Business Editor and New York Bureau Chief of The Economist. He was previously the magazine’s London-based Business Editor. His latest book, The Road from Ruin: How to Renew Capitalism and Put America Back on Top, with Michael Green, was published by Crown in February 2010. Philanthrocapitalism, his previous book (also with Green) on the global revolution under way in philanthropy, has been described as the definitive guide to a new generation of philanthropists who understand innovation and risk-taking, and who will play a crucial part in solving the biggest problems facing the world. He is also the author of Essential Economics, the official Economist layperson’s guide to economics, and has written several of The Economist’s special report supplements.
Before joining The Economist, Matthew Bishop was in the faculty of London Business School, where he co-authored three books for Oxford University Press on subjects ranging from privatization and regulation to corporate mergers. Educated at Oxford University, he has served as a member of the Sykes Commission on the investment system in the 21st century and was in the Advisors Group of the United Nations International Year of Microcredit 2005.
You make a very strong case for part of the blame, at least, for the crash lying with supine investors, particularly institutional investors, who should have been asking awkward questions of management and weren’t. How optimistic are you that this could change?
I look at Lehman Brothers or Bear Sterns or AIG, and try to understand why they took on so much risk that they were so obviously incapable of managing. But the other side of this coin is looking at stockholders who were far too tolerant of company boards that were consistently rated as weak by analysts. Lehman Brothers, for example, had a Broadway director and an actress on its board. Fuld (the Lehman CEO) put the board together and there is no real evidence that it ever played any useful role in providing the support and accountability that you want from a company board. Nor was the Lehman board exceptional. There were (and still are) an abundance of weak boards dominated by powerful CEOs. This is where the United Kingdom does a little better than the United States. At least the United Kingdom has standardized on the separation of the chairman’s role from the CEO’s role. That provides some creative tension at board level and this is enhanced by the fact that in the United Kingdom it is somewhat easier for institutional stockholders to nominate directors to the board.
So where does a weak board lead us to? Any cursory look at the performance of leading players in the period up to the crash shows that their activities were hugely skewed towards short-term risks with no one working to make the board a vehicle of accountability. Part of capitalism is that you treat the board as a source of strength. Instead, in the United States, too often the CEO simply sees the board as his/her personal fiefdom, captured from stockholders. It seems to me pretty obvious that all card-carrying capitalists should be on the side of the stockholders, not on the side of those the stockholders have hired to run the firm on their behalf.
Stockholder activism would seem to be easier where a significant volume of the stock is held by a handful of large institutions. Is it not much harder to get going when the holding is spread across a large number of stockholders?
There is no reason why a more diffuse stockholding should block a quorum of activists from making themselves heard. It does not help, however, that the way fiduciary responsibility is defined in the United States means that you have fulfilled your prudent man qualifications just by having a relatively diversified stock portfolio, and that there is no requirement at all to show that you have exercised any care or even used your vote across that portfolio. There is scope here for the law to change and such a change would have a very good impact on sharpening fiduciary responsibility.
How you vote as a stockholder is a fairly straightforward matter by comparison with more complex issues such as the derivatives market. What do you think of regulatory moves on derivatives?
Prior to the crash there was a great deal of nonsense spouted by those in charge of policy at the regulatory level as far as derivatives were concerned. One thinks, for example of Alan Greenspan’s notion that they were an ideal way of laying off risk on those best suited to take risk. Worse, there were people on the boards of banks who openly said that they did not feel that it was their job to understand derivatives. That kind of thinking is evidence of financial illiteracy in a place where it is crucial that you have financial literacy. One can extend this to the rule-makers. I think it is axiomatic that you need people in Congress, particularly those who are taking decisions about policy, to have a basic grasp of finance and economics. A great deal of the deregulation that took place in the years leading up to the crash was introduced on the back of a very superficial level of debate.
Of course there are dangers with derivatives and people had issued warnings about them long before the crash. I wrote a detailed article back in 1995 about the corporate use of derivatives. At the time I concluded that it was right for companies to use them to hedge risk in some circumstances; that they had a useful role to play. But I also warned that you should only use them if you understand them. A lot of companies use derivatives without asking the right question about them. If we turn to the sub-prime mortgage fiasco, banks were buying into collateralized debt obligations (CDOs) that consisted of parcels of subprime asset-backed securities, without asking even the most basic questions about house prices and interest rates. We are not talking here about rocket science. They did not ask the simple questions that anyone investing in the housing market directly would have asked. The fact that it is a derivative does not protect you from real-world events in the underlying market. It is now simply a matter of history that the ratings agencies, whose mission should have been to make sure that they did not give stupid ratings to dubious assets took their eye off the ball.
There have been a number of calls by senior politicians, particularly in Europe, for the ratings agencies to be “punished” or even replaced. What is your take on this?
It is not easy to replace the big ratings agencies. There is an oligopoly, with just three or four top agencies dominating the business and they are guaranteed money from people who need their ratings. There is a real question around how we make the ratings market more competitive. There is no totally satisfactory answer to the dilemmas that arise from people paying for ratings. Ultimately, you need the ratings agency people to care deeply about the long-term performance, and hence the long-term value, of their franchise. If that is their focus then they will do a good job. What happened with the sub-prime CDOs was that the ratings agencies lost sight of what was in their long-term self-interest. In fact, people confusing short and long-term success was one of the dominant problems of the crash. Capitalism should be a long-term game.
How satisfied are you with the way the US Finance Bill has gone?
What they seem to have done is to provide legal clarity around what the state should get involved in, but there is a great deal of detail that still remains to be resolved. So far we have seen a general move, both in the United States and in Europe, towards less risk, but this is not a sustainable change, I would have thought. When things get better and people’s risk appetite returns, there is nothing so far to stop excessive risk taking from happening yet again.
The introduction of a Systemic Risk Council is new, but its function is largely window dressing. The regulators had similar powers in the past but simply did not use them. The plain fact is that the regulatory authorities felt much more relaxed and comfortable than they had any right to feel. What I would have liked to see from the Finance Bill was much more emphasis on requirements for companies to provide much more information to the markets. That would enable market participants to do a much better job of managing their own risks and of using novel ways of measuring risk in the system. There is not much going on in the Bill that relates to the provision of additional information.
There is a real tension here between letting the market decide about a particular company’s prospects and whether it is over-leveraged and so on, or having supposed expert regulators decide. The experts are supposed to take the long view based on the underlying fundamentals of the stock, while the markets give you instant market sentiment. If there is one thing that we have learned from the crash it is that markets can sometimes get it wildly wrong. So it is important to keep an eye on what the market is doing, of course, but it is equally important for regulators to take a longer view to see that what is happening to the market is not a bubble or a short-term shorting blip.
That said, the US Finance Bill has some real potential, depending on how its details are defined in the coming months. There is nothing in there on pensions, which is a big omission. There are some mild improvements but no change in fiduciary responsibility. I suppose I am both disappointed and relieved that what is being proposed is not more damaging to the economy. I am not at all certain that those who would have liked to see the reintroduction of Glass–Steagall, with a complete separation between risk-taking and depository banking, are right. That was a good formula for the mid 20th century. It worked well in an environment where the United States was a self-contained economy. Now we are in a world of universal banks and the United States recognizes that it operates in a global market. There are real issues around how one defines proprietary trading, or so called “casino banking.” A lot of what politicians and others think of as proprietary trading by banks is actually for the benefit of clients. Wall Street CEOs generally point out that businesses accounting for only around 2% of their profits would need to be spun off under a Glass–Steagall regime precisely because so much of proprietary trading is integral to commercial banking.
There have been calls by hard-line capitalists for the abolition of the Federal Reserve, as an unjustifiable interference in the workings of the market. What is your view?
Those people who call themselves hard-headed capitalists and who oppose the Fed are simply bonkers, but they follow in a long tradition in the United States in certain quarters of opposing the Fed. The origins of the Fed go back to the moment in 1907 when JP Morgan had to force the bankers to bail themselves out by locking them all in a library until they had agreed to set up a bailout fund. You need a stabilizing force at the centre of things and it is important to remember that the Fed came into being at the behest of Wall Street. The same people who argue for the abolition of the Fed also argue that everything should be deregulated and that the markets should be left to get on with it. We saw where that leads and we now know that you need smart government, rather than big government, as an integral part of the market. We had the alternative with Paul Mellon in the 1930s saying that the cure for troubled banks was to liquidate, liquidate, liquidate. Had we gone down that road in the recent crash, we would have 25% unemployment in the United States right now.
Does the scale of the US deficit disturb you?
There is a potential crisis if the United States does not address long-term financing challenges. It is not going to turn into Greece overnight, but if it continues to borrow as heavily, and fails to tackle some of the spending requirements for retiring baby boomers, that is where it could finish up. However, there is a window of opportunity to do something about it. There were fundamental weaknesses in the US economy before the stimulus package and quantitative easing began and those underlying problems are exacerbating things. I do have concerns that there is still not the political will to address these issues.
The US situation is sometimes likened to Japan’s lost decade. In The Road from Ruin, we write that Japan’s lost decade was prolonged by that country cutting the stimulus at the first signs of growth. The paradox with this situation is that there is a clash between short and long-term policy requirements. In the short term the economy absolutely needs to be stimulated. In the long term you need a return to sound finances, and the transition between the two is fiendishly difficult.
Matters are not helped by the distortions introduced by the US dollar being the world’s de facto reserve currency. Having one economy control the world’s currency is increasingly more problematic. This was the case in Britain with the gold standard and it is increasingly the case with the dollar. As we have seen, there is a flight to the dollar when the world is worried, so the dollar strengthens even in bad times. But this underpins some really severe distortions in the global economy. It encourages the Chinese and others to buy dollars and to lend them back to the United States at very low rates of interest, thus stimulating asset bubbles in the United States. In the book we raise the question of whether it would be better to plan for a new reserve currency. I believe that the United States should be a major part of that planning. There is no doubt that Britain lost out by not planning for a replacement to the gold standard.
You place considerable emphasis on the importance of improving financial literacy generally as one of the best means of securing the economy. How is this to be achieved?
There is a whole range of things that could be done to get more financial knowhow out there. Efforts to date on the part of governments have been very superficial and tend to amount to no more than a few classes in basic economics at the age of 15 or 16. Another popular attempt is to get school children to play stock market games. If anything, that encourages people to misconceive the nature of investing. What you want is an educated population, with citizens who can think constructively about issues such as whether a government can meet its fiscal obligations. For this you need a relatively informed debate and currently the school systems in Britain, Europe, and the United States are not geared up to produce the deeply informed citizens that democracy needs if it is to thrive. Without this, you get politicians staying at the level of sound-bite posturing. Improvement in financial literacy is possible, but it will require a lot of hard thinking and serious effort.
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