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Financial Crisis: Confidence—and Some Cautions

10.13.08

This post summarizes the October 13 panel discussion on "Leadership for the Twenty-First Century," moderated by journalist and television host Charlie Rose and a pair of addresses on globalization...

The planners of the Harvard Business School (HBS) centennial "Global Business Summit" being held on campus October 12-14 of course could not have known that it would take place during a severe financial crisis worldwide (and perhaps at the early stage of a rough recession). But having convened business leaders from around the planet, HBS made possible a timely conversation on current challenges and the likely path ahead. This post summarizes the October 13 panel discussion on "Leadership for the Twenty-First Century," moderated by journalist and television host Charlie Rose [see video], and a pair of addresses on globalization (including one by economic and business historian Niall Ferguson, recently profiled in Harvard Magazine [see video]). A separate post covers the presentation on "creative capitalism" by Bill Gates. Further posts cover sessions on business education (with HBS dean Jay Light and Harvard president Drew Faust); and on leadership and on "the future of market capitalism," including an address on the current situation by Eliot University Professor Lawrence H. Summers, whose outlook on "The Economic Agenda" appears in the current issue of Harvard Magazine.

"LEADERSHIP FOR THE TWENTY-FIRST CENTURY." Light prefaced the centennial discussion of leadership, globalization, and the future of market capitalism by saying "little did we imagine" current circumstances when planning for the events began two years ago. Now, he said, "The times call for serious reflection and deep inquiry" on Wall Street and Main Street, in government, in corporations, and in business schools about what happened, what should have been done, and what must be done—and effective leadership is key. To that end, he recognized five HBS Alumni Achievement Award winners, who would make up the panel:

John Doerr, M.B.A. ’76, venture capitalist at Kleiner Perkins Caufield & Byers.

Jeffrey R. Immelt, M.B.A. ’82, chairman and CEO of GE.

Anand G. Mahindra, M.B.A. ’81, vice chairman and managing director of Mahindra & Mahindra Ltd.

Meg Whitman, M.B.A. ’79, past president and CEO of eBay, national co-chair of the John McCain presidential campaign.

James D. Wolfensohn, M.B.A. ’59, chairman of Wolfensohn & Company, LLC, past president of the World Bank.

Rose asked for views on the current crisis and steps necessary to regain confidence in markets and in individuals' personal financial security. Whitman saw an "unprecedented challenge" to the global financial system, and an urgent need for people to be "enfranchised into the solutions" through careful explanations of what had happened and what remedial steps were being taken. Leaders, she said, had to "tell the truth" about the situation; given higher food and energy costs and the losses in retirement accounts, she said, "most American consumers are deeply afraid," but there are "glimmers" of returning confidence.

Mahindra chose to be a contrarian, and urged against rushing to build a new world order or global financial system on the fly. Rather, he said, matters need to be "reset." Choosing the British phrase, he said "merchant bankers," as opposed to recently high-flying investment bankers, needed to "return to their passivity" as agents of others' transactions (rather than as highly leveraged principals on their own). The environment is not unprecedented, he said, and the situation did not call for cries of "The king is dead, long live the Politburo!" Rather than rushing to nationalize banks, he counseled, people should expect the U.S. economy to be resilient, to rebound quickly—especially if credible leaders would talk up that potential. The world's economies were clearly coupled, he said ("The world today is about line dancing, not solos"), so it was hubris to think that developing nations would be unaffected by problems in the United States and Europe. But overall, he had confidence in the strengths of the American market economy.

Immelt saw the credit crisis beginning in August 2007, as mortgage markets and the synthetic securities assembled upon them weakened, and then reaching an "unbelievable" crescendo in the violent market events of this past September. But, he said, "I'm pretty optimistic now. The government always wins" in such situations, and has begun to address the twin problems of declining housing prices and illiquidity as manifested by banks' unwillingness to lend. A recession is in the offing, he felt certain; but if the liquidity problem is addressed, the government will be able to respond appropriately: "We've got an activist Fed[eral Reserve Board], an activist government, not just in the U.S. but around the world," which would promote a positive outcome. For his own company, active in most markets, the financial-services business would certainly face a cyclical downturn as "risk is getting repriced" (appropriately, after no-down-payment mortgages and huge, loosely secured loans to private-equity firms); but the industrial business was fine, with a $170-billion backlog of jet engines, wind turbines, and more.

"This crisis comes at an unfortunate time for U.S. leadership," Doerr said, since the current administration cannot provide the kind of confidence that the public requires (compared, say, to the reassurances offered by a Warren Buffett, who has a long track record in weathering business cycles successfully). Entrepreneurship, science, and innovation are "racing ahead," Doerr said, despite the current traumas, and provide great hope for future growth. But he warned, "You can bail out the economy. You cannot bail out the environment." Compared to climate change and global warming, the current credit crisis is a "minor blip." The real challenge is "decarbonizing our economy," and doing so is the best opportunity for creating new jobs. Would a new president be too constrained to proceed in that direction, Rose asked? Quite the contrary, Doerr thought: the next president "will have great scope to do things that the current president cannot," as the country and world seek strong leadership.

Wolfensohn agreed that the government had begun to intervene helpfully to provide banks adequate capital and to assure sufficient liquidity. But he cautioned that no one has a fix on "what is the quality of the assets" banks hold. In the past 30 years, he said, Americans' household debt had ballooned from $700 billion to $14 trillion, and the quality of those loan assets on banks' books was far from confidently known. Globally, the problems that began in the United States are rippling broadly across not only the developed, industrial nations, but into the developing markets, where stock-price declines of 50 percent and more are "not trivial moves." It might be imprudent to look to the five billion people living in such nations to provide the needed spark for growth. Rose asked if the government were doing the right thing to invest in banks? "At the moment, there is no one else" able to do so, and the capital is required, Wolfensohn said.

In the general discussion, among the points made were:

This is only the "beginning of the credit cycle," Immelt said, with future results depending on whether one did a poor or a good job of underwriting from 2001 to 2007. Mahindra said that banking was, as always, a relationship business, based on evaluation of customers' characteristics, so "This crisis makes you believe in God again." The "reset" in banking was a good thing, he said; in India, his company's business of making rural loans is growing at a 40 percent rate, following sound banking fundamentals.

Consumers are pulling back, Whitman emphasized, unlike their continued willingness to spend through the dot.com bust of 2000-2001; and since consumers account for 72 percent of U.S. GDP (versus about 60 percent in Germany), something needs to be done to "solidify them" to stave off what could be a multiyear, deep recession. Immelt thought a recession need not be that long if the credit markets are repaired; but if liquidity remains constrained, he foresaw a more protracted problem. Wolfensohn pointed out that household debt substantially exceeds household income, a new and worrying situation, so consumer borrowing capacity is very constrained. Immelt noted that liquidity problems with a modest recession presented a very different challenge from liquidity problems with 10 percent unemployment—the challenges were binary, not complementary.

Doerr said the largest problem was that the U.S. borrowed money from China to buy oil from the Mideast to burn it—and that the "borrow, buy, burn" cycle "has got to stop" at each point of the process.

Mahindra saw capital accessible—for example, from pools of funds accumulating in the Middle East—and compelling opportunities to tap that capital to invest in the United States, where fundamental economic strengths, free markets, and entrepreneurship remain more attractive than anywhere else.

Doerr said that entrepreneurship remained strong in the "bits and bytes" of Internet and digital engineering (which he thought had perhaps run its course, and where companies would fail, despite their modest capital requirements); in the "bugs and drugs" of biotechnology; and in the "batteries" and other developments of the emerging green economy and clean-energy industry (where capital is required to get inventions scaled up and running). Immelt said that while GE and presumably others would remove costs from their financial-services businesses [to support which GE raised $15 billion in new capital last week, and reduced internal payments from that business to the parent company], but that in the industrial business, the current circumstances provided an opportunity to "pour it on" in investment and attempts to gain market share. He recalled the events of 9/11 [Immelt took office on September 7, 2001], when GE's huge jet-engine and airplane-leasing businesses faced a worldwide convulsion in the aviation industry; between then and now, he said, GE had invested heavily, gained market share, and increased its base of equipment installed [on which it makes money from servicing contracts].

Leadership in the public realm—and the presidential election campaign. Rose asked what issues the panelists would most like the candidates to address. Wolfensohn said that campaigns naturally focused on short-term concerns, but "the one thing that I yearn for" is discussion of the long-term challenges: environmental and climate change, and preparing for a future in which the world population rises from six bilion to nine billion while the share of income accruing to the currently developed nations shrinks sharply with "the move back to Asia in every sense."

The nature of capitalism and the changing role of government. Immelt said that from 1980 to 2000, there was little interaction between business and government. Now, he said, in light of new problems—addressing healthcare, for instance—the sectors were cooperating more closely; and the financial crisis assured that there would be more regulation. Doerr said that the greatest private opportunities in history arising from the greatest challenge ever (addressing the energy problem) would necessarily result from "policy together with private capital." He underscored the urgent need for research and development: U.S. spending on renewable energy research and development totals less than $1 billion annually now, he said. Immelt said energy, for instance, could be addressed; since World War II, research had focused on defense, health and healthcare (the National Institutes of Health), and space exploration (NASA). Progress in using energy efficiently and in producing it benignly did not depend so much on new discoveries as on commercializing what was already known. As a life-long Republican who believes in free markets, Immelt said, "The notion that government isn't the catalyst for change is just garbage."

Whitman agreed with all of that, and said pursuing an alternative energy future was the "moonshot" of the next decade, with government as both the partner for innovators and industry, and as the focus for Americans' efforts: the American people, she said, are "dying to be asked to help solve the problem," as they tragically were not asked to make some common cause after 9/11 (beyond being called up on to "go shopping," Rose said—not altogether a bad thing, Whitman observed).

America's global position. Half a century ago, Wolfensohn said, America's advantage was its wealth. Today, China has $1.7 trillion of foreign-currency reserves, Russia $500 billion, and India $400 billion—and the United States just $72 billion. "The one thing" that the U.S. can use today is "technology and innovation." The country "can't buy its way out" of its problems, having borrowed $800 billion last year alone, as its national debt has doubled to $10 trillion and threatens to balloon still further. To prepare and compete, students need to study abroad in Asia as well as in Europe because "It's no longer a transatlantic world."

Immelt went further, tossing aside the developed-developing world dichotomy. GE saw a tripartite world: natural-resource-rich nations (the Middle East, Brazil, Australia, and so on); people-driven regions (India, China, southeast Asia, where serving huge markets demands that companies be local in their presence); and technology- and education-rich regions. In this context, every country has to work on its competitive position: none can assume that it is economically competitive simply on the basis of its presumed current strengths. Doing so involves having a clear view of education; healthcare; energy policy; and the ability of the financial system to promote innovation. When Rose asked how Immelt would approach each, he said he would encourage a leader to pick two or three clear goals for each sector, and to pursue them.

International perspectives on America. Mahindra said the Bush administration had been productive for India (trade agreements, supporting open trade and defending outsourcing, signing a nuclear agreement) and that John McCain would likely be similar, but that in his heart, Barack Obama [J.D. ’91] represented "the finest that America has to offer," particularly as the world tries to get past the "excesses" of U.S. expansionism. Whitman said she was "tremendously proud" of Obama, and that his candidacy had been a "great thing for America." Her priorities were energy independence, getting the national debt down (since, as HBS students learned, "revenues need to be more than costs"), and education.

Managing the financial crisis. All of the panelists thought that the current leaders of the Federal Reserve Board, Department of the Treasury, and others had coped with the crisis as well as could be expected, and honorably. Immelt saluted the involved leaders for "being in there with their shirt sleeves rolled up," entertaining new ideas daily as necessary, even as he, and they, were "numb" about how much has gone wrong, so fast, in the financial system. Wolfensohn recalled a late-August dinner with several of the principals, none of whom then had an inkling of the crisis that was about to burst upon them. For all that, Doerr said, no steps taken so far had addressed the problem caused by "putting homeowners in homes they can't afford under mortgages they can't afford more and more," many of which would have to be rewritten into conventional 30-year, fixed-rate loans reflecting current market values. [For complementary perspectives on this aspect of the problem, see the comments by HBS professor of management practice Robert Kaplan and Gottlieb professor of law Elizabeth Warren in a Harvard panel discussion on September 25, summarized here.] More generally, Wolfensohn said, the American "consumption society" is now spending vastly more than it earns—and the recent rise in homeownership had been accompanied by a rising number of situations where the resident families have no equity at all. The country has to get "back to spending what we earn, or we're finished as a society."

Said Immelt, "We have a country right now that just isn't self-confident." To that end, he would pick one huge problem—energy was his choice—and solve it. Doerr, who said "I worship entrepreneurs," implicitly endorsed Immelt's formulation: ideas are easily come by, he said, but "It's execution that's everything."

"GLOBALIZATION." In his address, Filene professor of business administration John A. Quelch (who is senior associate dean and chair of the faculty committee that planned the centennial) posed five questions about globalization that every business leader needs to address:

• Is the world truly "flatter" and more integrated economically—or will the current financial crisis emphasize differences among distinct nations and regions?

• Has globalization benefited humanity?

• Has globalization benefited the United States (in light of criticisms from both ends of the political spectrum about the job losses to outsourcing, the country's dependency on other nations for capital and strategic skills, and rising commodity prices that hurt workers whose incomes may be depressed by new competitors)?

• What leadership role can the United States expect to play in the world—given its role in spawning the economic crisis, and eight years of government indifference to global warming and climate change?

• What is the role of international financial regulations and institutions—in light of the surprising economic success of authoritarian and mercantilist regimes, and criticisms of the International Monetary Fund and other entities as insufficiently inclusive?

These questions were subsequently explored in nearly two dozen classroom sessions, but they were first framed by Niall Ferguson, the economic historian who is Ziegler professor of business administration and Tisch professor of history—author of the forthcoming The Ascent of Money: A Financial History of the World and host of the associated public-television series.

Ferguson posed the question—which he didn't directly answer—of whether globalization makes economies inherently crisis-prone.

Globalization is not new, Ferguson noted: in 1908, when HBS was founded, an English-speaking nation (Great Britain) held sway over an empire that included a quarter of the world and its population; there were worldwide telegraph cables and shipping lines facilitating commerce; labor was mobile; and trading on the London stock exchange was global, facilitating capital flows (from Great Britain, which had a huge pool of funds), all underpinned by fixed currency-exchange rates backed by gold. Today, the world exonomy is truly global, albeit with differences: there are international institutions (the IMF, the World Trade Organization), and there is huge trade in services (not only goods), as well as a large volume of foreign direct investments. In 1907, as now, there was a severe global financial crisis—then, spurred by manipulation of the copper markets, short selling, and a bank squeeze when the attempt to corner copper failed.

In the ensuing century, there has been strong real growth, with the Standard & Poor's 500 index up 131-fold in nominal terms, and five-fold in inflation-adjusted terms (even after the market crash this September and early October). But there have been three great crises, Ferguson said: the Great Depression; the stagflation of the 1970s; and the current one (which he called the "Great Repression," as market participants, in denial, repeatedly failed to face the crash in a timely way).

The risk, he said, is that the global economy is "overoptimized": companies are so tightly managed, with just-in-time delivery, that surges in demand cause price spikes (as in the prices of commodities), and financial glitches ripple through the system rapidly. That is, the gain in efficiency in current business and financial markets is accompanied by "maximal vulnerability."

Crises occur in an irregular pattern, Ferguson noted, making them especially disconcerting. "Financial crises are much more frequent than we expect," he said—in fact, every 10 to 15 years—but "with no predictable frequency." Nor is the magnitude predictable, especially in a globalized world where "a subprime default in Memphis takes down a bank in Iceland."

Putting on his historian's hat, Ferguson was scathing about financial strategies based on models which lack sufficient perspective. Given the frequency of crises, he said, models with five years of data cannot possibly work. "Models are to be blamed for this crisis," he said, pointing to financiers' erroneous assumptions that they could guess the frequency of stress points, that liquid funds would always be available in the credit markets, and that adverse price movements in the securities markets are random. Nor is relying on life experience sufficient: even current Wall Street leaders, who average 25 years of experience, Ferguson said, have too little hands-on knowledge to navigate through the crises they can be expected to confront. As recently as 2004, he noted, Federal Reserve chair Ben S. Bernanke ['75; see here] spoke with comfort about the "Great Moderation" in economic conditions effected by better monetary policy, and his predecessor Alan Greenspan hailed the increased "resiliency" of the financial system.

A better model, Ferguson thought, was to imagine the economic system as an evolving system, with characteristics of biology as shaped by the living dynamics of Darwinian evolution. In that context, the financial system had seen incredible evolution in the past two decades, in product forms (mortgage-backed securities, derivatives, and so on) and institutions (hedge funds, private-equity funds, sovereign wealth funds, and structured investment vehicles—SIVs, which Ferguson joked leaked money like sieves). But, he noted, living systems evolve through random mutation, and both create new species and have old ones die out; they are not, in other words, subject to intelligent design. It is more than misguided, he suggested, to assume that economic systems are subject to benign, intelligent design.

That suggested two cautionary lessons. First, Ferguson strongly embraced the model of "creative destruction" as the motive force in capitalism as elaborated by Joseph Schumpeter. Second, he said that regulation—often after the fact, often plagued by moral hazard—could become an obstacle to the innovation that is fundamental to markets and capitalism.