The Future of the Financial System

Interview with FEE Chairman Wayne Olson

In June, I sat down with Wayne Olson, chairman of the board of Foundation for Economic Education (FEE), one of the oldest free-market organizations in the United States to talk about the future of the financial system. Mr. Olson spent most of his career as a banker focused on fixed-income products with the international financial services institution Credit Suisse. Drawing from his extensive experience, we discussed the financial crisis, Wall Street’s culture of risk taking, financial services regulation, the housing market, and inflation concerns.

Anthony Randazzo, Reason Foundation: Thank you for taking the time to speak to me today, Mr. Olson. With my first question, I’d like to get perspective on where you’re coming from. Our leaders’ decisions are profoundly influenced by their perspective of what caused the housing bubble and who is responsible for the financial crisis. What is the framework that you use to approach events in our tumultuous economy?

Wayne Olson: The folks in Washington have defined the causes of the crisis to exclude themselves. But they are the prime motivators for what happened and what’s going on. In terms of framework, I’ve never seen a plainer example of the textbook Austrian business cycle theory than what we’ve just gone through. Monetary excess causes distortion in investment decisions, and it causes over-investment in long-lived capital goods, as well as excessive consumption because of artificially low interest rates and high liquidity. As a result, the asset prices become grossly inflated and unsustainable.

Randazzo: Do you have a sense of what would have happened if the Federal Reserve had tightened the money supply in 2004 or 2005? Do you consider the arguments that tightening monetary policy would have had some negative impacts in the American economy plausible?

Olson: You mean defending the dollar would be a bad thing?

Randazzo: So you don’t think that that tighter monetary policy would have had a long-term negative impact on the country? What about trade?

Olson: Well, yes, on the margin, a valuable dollar makes it more difficult to export and any tightening after a period of ease is likely to produce a downturn, but probably nothing so severe as what we ended up with anyway. There are costs and benefits to everything, and a stable currency is generally a good thing. That is the upside of more prudent monetary policy. The downside of easy money is what we face now with the credit markets, the economy and the dollar all being more vulnerable than they should have been.

Randazzo: In A Failure of Capitalism, Richard Posner writes that traders and investors on Wall Street acted rationally with high leverage, given the implicit government guarantees on risk. Would you agree?

Olson: You know, there’s this thing called agency theory. Problems will always arise in any business organization when the people who run it are different from the people who own it. It’s no different in a large financial institution from anyplace else. Over the past twenty years or so, there’s been massive consolidation in the financial services industry, for a lot of good reasons. Optimal scale became much greater. A bunch of partnerships went public, and the classic example of a place where you have agency inefficiencies is a publicly traded corporation. So it is not news that the employees will tend to run an organization for their benefit, and not necessarily for the benefit of shareholders.

Randazzo: So, would it be helpful to design regulations that incentivize partnerships?

Olson: If you create a regulation that requires a particular form of business organization, you address one problem and you create a myriad of others. The problem with using incentives to encourage partnerships is that you’re implicitly assuming that you know what the optimal capital structure is of that industry. And if you create an implicit government guarantee, you’re going to create increased risk-taking behavior.

Randazzo: Given your time on Wall Street, do you feel that there’s a culture of excessive risk taking on Wall Street that regulation can’t fix, or is there a way to align investor interests with systemic risk concerns?

Olson: Well, when you talk about behaving responsibly, you have to understand the consequences of responsible and prudent behavior. The responsibility of a market maker is to be correctly positioned for the market as he finds it. In 2006, the prices of credit were razor thin, very low rates for borrowers, high prices for investors. If you took a contrarian view of subprime mortgage-backed securities and said, “these prices for risky assets are too high to be sustainable, I’m not going to buy any more of these subprime loans and distribute them to my customers,” then you’d be shutting down an operation that was generating several hundred million dollars a year in revenue. Making this courageous decision would mean firing fifty or a hundred people. Other firms would hire all your people and laugh at you because they’re making all this money while you watch. It takes a significant amount of courage in your convictions to take that view against what the current market is telling you.

Randazzo: So the nature of Wall Street’s drive for gain drove many people to invest in unwise ways?

Olson: To be fooled by distorted market signals, yes, but I will add that regulatory policies have significantly exacerbated that agency problem and the willingness of institutions to take on risk. When you create this concept that certain things are too big to fail, you increase the optionality of working at a place like that, meaning that upside potential exceeds downside risk.

Randazzo: Do you think it is fair to say that regulators can’t keep up with financial product innovation?

Olson: Senator Chuck Schumer from New York once said that if somebody had been properly positioned as a regulator of Bear Stearns, then they would have had all the facts, and they would have been able to see ahead of time, to say ‘look, you’re taking too much risk here, you’ve got to scale back’, and would’ve had the authority to make that happen. But let’s look at the implications that are involved there.

There’s too much information! This is the classic fallacy of central control. The fact of the matter is that the people at Bear Stearns had all of the information, and they couldn’t figure it out, right? It’s a hellish task to absorb it all and figure out all that information and you’re never sure you’ve got it right. So in Senator Schumer’s scenario you’ve got an omniscient person that’s smarter, with a greater ability to absorb information and analyze it than the folks at Bear Stearns. And you have a wise person, a person of discernment, who would’ve known that the risk was too high. But the guys who do that for the regulatory agencies are no different from the guys working in the credit department at Bear Stearns. The guys who work at the FDIC are the same guys. They went to Wharton, they studied finance, they built models, they worked in banks, they are the same guys. How are these people going to be omniscient? They’re going to absorb the information and analyze it better and make wiser decisions? Because they’re motivated to carry out the public trust? That wouldn’t make them any smarter, and besides, they’re motivated to keep their careers going.

Randazzo: Would the creation of an FDIC insurance and receivership authority for non-bank financial institutions exacerbate a too interconnected to fail system, or is it an appropriate part of regulatory structure?

Olson: The first part of that question is whether it is appropriate to put some kind of government insurance on the obligations of non-banks. And I think it’s a dumb idea. It creates all the distorted incentives that the FDIC’s guarantee on deposits creates. In terms of receivership, my view of the FDIC is actually very positive. I’ve dealt with them in a number of situations when I did work with resolution agencies in the government. Ours is a profit and loss system, and loss is supposed to imply failure. The government, in creating the rule of law, creates ways that we deal with failed institutions, and in my view, the FDIC in general is a very efficient and effective tool for dealing with failed banks. However, non-bank financial institutions are already covered by federal bankruptcy law, which is also pretty good and does a better job of balancing the rights of multiple classes of creditors. Chapter 11 is a very well developed and smart thing that should have been allowed to operate in the case of the auto companies and AIG. The problem is, it’s not being permitted to operate, because certain people’s interests are being protected. The problem is that the government in Washington doesn’t observe the rule of law.

Randazzo: The Obama administration’s regulatory proposal suggests that it is important to fix the financial services sector’s regulation quickly so that the American people will have confidence in the financial structure. Do you believe that consumer confidence is an important aspect of recovery?

Olson: There are several elements of confidence. The most important element of confidence in recovery is the confidence of entrepreneurs and providers of capital. Confidence can’t be manufactured. The confidence born of rational, prudent decision-making is the kind of confidence we need. The notion that reshuffling the regulatory framework is going to restore confidence in the financial services sector and is going to make me buy stock in Citigroup is ludicrous. The regulatory framework around financial institutions has grown up over almost one hundred years. There were a lot of smart people that put in years and years of thought and analysis into a certain design. The notion that re-jiggering the thing in the space of three months is going to restore confidence is insane. What it will do, what the behavior of these regulators has done, is impair confidence in the rule of law. And how about confidence in the dollar? That would be a good thing. I don’t hear anybody talking about that.

Randazzo: Let’s talk about that, confidence in the dollar. There is a lot of debate within the Federal Reserve about how to handle inflation concerns. What do you think the Fed’s best reaction is in this case?

Olson: There’s not a whole lot the Fed can credibly do or say, because I don’t see how the deficit is going to get funded other than by monetizing it. They’re saying the right things now about not monetizing the deficit. Yet, the quantity of new debt that needs to be issued by the treasury to finance its operations over the next few years is astronomical. And who’s going to buy all of these treasury bonds? To the extent that foreign nations don’t, the bonds are going to absorb more of the savings in the United States, and interest rates will naturally rise, because corporations will have to compete with the government for credit. Or the Fed’s going to step in and monetize the deficit, and you’re going to have a massive increase in money supply.

Click here for Part II of the interview with Wayne Olson, where we discuss taxes, the housing market, moral hazard, the importance of contracts, economic education, and what the prospects are for recovery.