#HBRLive: The Cost of Wall Street's Power

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0:59Gautam Mukunda:This is Justin Fox from the Harvard Business Review. I'm talking to Gautam Mukunda, professor at Harvard Business School and author of an article, and I should have shown it before, the June issue of HBR. Apparently the baby is wearing your glasses. Exactly. I lent them out. And the article is titled, The Price of Wall Street's Power. And what we were talking about just now is what happens when an economy and a political system get out of balance and there's a player, in this case Wall Street, that I don't know if it's too much power, but it certainly has a lot more power than it did 40 years ago.

1:38Yeah, and to a remarkable extent. In fact, I'd say that the role of finance in American society now is at a level that it had not had until, perhaps not by coincidence, just before the Great Depression. And so when you look at that, what happens here is that over and over again you just see a shift, not just in what happens, right? So there are direct exercises of power where the government does all sorts of things that favor the financial sector, and we know about lots of them, right? It's not just that we had to bail out the banks in the financial crisis, that I think a lot, most people thought that was the right thing to do, I did.

2:10It was that we did it at extraordinarily favorable terms, right? We essentially get, the classic way to think about this is Warren Buffett got much better terms from Goldman Sachs than the United States government did. And there's something really odd going on when Warren Buffett can get better terms from these banks than the United States government, which after all is rescuing not just any one company, but the entire industry. So part of it is this, that we do things like this in a very favorable way to the sector. And that imposes an enormous cost on society and something we really need to do something about.

2:43But it's not the most important factor. The most important factor is the way in which this imbalance in power actually changes the way people think about the world. and this to me is actually the nut of the problem that when you see managers who are running their companies as they say, we don't do well managers are told that they need to run their company because they have a fiduciary responsibility to maximize shareholder returns now as a professor from the University of Michigan has demonstrated quite clearly as a matter of law that's simply not true a fiduciary responsibility implies a specific type of legal obligation in the United States that does not exist in the terms of maximizing shareholder returns.

3:24It simply does not. So what's really fascinating here is not that fact, right? That's important. The really interesting thing is, why does everybody believe? Why do so many managers believe that that's what they have to do? Why are so many companies run as if that's what they have to do? Why do we pay managers through stock options and other forms of compensation as if the only thing we want them to do is to maximize shareholder returns and not maximize any of the other things they could actually be doing. And to me, that's actually what's going on. That's a consequence of power, where the power of the financial sector isn't just making us do things, it's making us think in a certain way.

4:00And in this case, in a way that is particularly favorable to its interests.

4:04Gautam Mukunda:Well, and that's something, again, 40 years ago, you talked to a CEO manager of a corporation, and they would probably put their job in pretty different terms than they do now, right? Absolutely. I mean, both in terms of power and prestige, there's been this huge shift. There's the famous line, I can't remember the CEO who said it, right? But what's good for GM is good for America. And then what people miss is that what he was also saying is that the larger primatex of the country is saying is what is good for America is also good for GM. Right? That he was thinking of himself as the CEO of an institution that was part of a larger society and had a network of values and important that essentially these are companies that could not flourish if the larger country was not flourishing as well.

4:48From this, we have a very different perspective where you will see right before the financial crisis. I think if I recall correctly, John Reed, I think famously said, right, that we're Citigroup is a company that just happens to be headquartered.

5:00Gautam Mukunda:Hey, Chicago, class it up with Crocs. You know, back to school is coming in fast. So why wait to find your new fave footwear? Step into a local Crocs store and step into your new look. Try it. Style it. Make it yours. Because the right pair doesn't just show up, it shows off. First day fits, handled. Walk out ready for whatever's next. Visit your nearest croc store today. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsored Jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills, certifications, and more. Spend less time searching and more time actually interviewing candidates who check all your boxes.

5:47Listeners of this show will get a $75 sponsored job credit at Indeed.com slash podcast. That's Indeed.com slash podcast. Terms and conditions apply. Need a hiring hero? This is a job for Indeed sponsored jobs. In the United States, it's not really an American company. Now, okay, once people need Uncle Sam to bail them out they change their tune pretty quickly, right? That's true. But more broadly you wouldn't, two generations ago, you wouldn't have seen American managers talking that way. It would have been almost inconceivable. They understood that they were Americans first and they had obligations that stretched beyond those to their shareholders.

6:20They had obligations to create value. So what I would say is if we just say that what we have is a sort of duality, right? You could say that your only obligation is to maximize shareholder returns. And there are lots of ways to do that. One might be to create wonderful new products that create new industries. But another might be to squeeze labor to the breaking point or to do things to your customers to minimize their value. And essentially what you're doing is you're transferring that wealth from customers and from employees to your shareholders. And since nowadays senior executives are major shareholders in their companies for the way we grant option grants, you are perhaps not by coincidence transferring it from customers and employees to yourself.

7:01well that transfers a lot of value but it doesn't create anybody nobody except you is better off and as an aggregate the whole group of people is probably worse off instead we could tell managers we could tell companies that your job is to create value your job is to operate in such a way that everybody is better off for as much as possible right that everybody that you know you create value for your shareholders by creating value for everybody and some of it goes to your shareholders and some of it goes to your employees and some of it goes to you that's what you do I think when we look at Steve Jobs, you know, you hear a lot of people sort of, there's this criticism, right, that we're criticizing the wealthy for having made money.

7:36And I think I want to, let's just say there's a split out there, right, that you often hear this critique and I'd say, you know, nobody ever criticizes Steve Jobs for getting rich. I've never heard anyone say, I really have a problem with the fact that Steve Jobs is really wealthy, right, because everybody acknowledges that Steve Jobs created an enormous amount of value for society, for his shareholders, for his employees. and in that process he made billions of dollars for himself? Well, good for him. I think we all applaud that. I think where people have problems with people who have become extraordinarily wealthy not by creating value, but by transferring it from other people's pockets into their own.

8:09And that seems to be something that happens a lot more in the financial sector than it happens anywhere else. And also it is something that this sort of financial thinking, where the only thing that matters are financial returns, encourages everyone to do more and more. And that's really dangerous.

8:23Gautam Mukunda:So that statement that this happens more in the financial sector than elsewhere, basically allocating value instead of creating value, is there evidence to back that? I sort of have that sense too, but I always wonder if it's just my own personal bias because I don't make as much money as the people who work. So there absolutely is evidence to back this up. In fact it's not my research. research, Andre Schleifer published a paper that I cite in the article in HBR that talks about the fact that a huge amount of the value that is captured in the financial sector is a product of rent seeking. So rent seeking is this idea that basically where instead of creating value, what you're doing is manipulating government policy in order to sort of generate profits but not economic returns.

9:13So the people as a whole are not better off. And so there's actually a great deal of research on this topic. Another way to think about it is just sort of in a common sense fashion, right? If I am buying a car, so I bought a car a few weeks ago for the first time in my life. I'm very excited. And, you know, the people I bought the car from, they are really hoping that a year from now, I will think back and say, you know, I'm really glad I made that decision. I would rather have the money than the car. Because they will say, you know what, I would rather have, I would rather, they will say, sorry, they want me to be saying I would rather have the car than the money.

9:44And they will say, you know what, we would rather have the money than the car. everybody's better off in that exchange right there has been value created but in the financial sector a lot part of what happens it's just much harder to do that right sales and trading speculation when you do this kind of stuff well if i sell you a stock hey chicago class it up with

10:03Gautam Mukunda:crocs you know back to school is coming in fast so why wait to find your new fave footwear step into a local croc store and step into your new look try it style it make it yours because the right pair doesn't just show up, it shows off. First day fits, handled. Walk out ready for whatever's next. Visit your nearest Croc store today. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsored Jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills, certifications, and more. Spend less time searching and more time actually interviewing candidates who check all your boxes.

10:46Listeners of this show will get a$75 sponsored job credit at Indeed.com slash podcast. That's Indeed.com slash podcast. Terms and conditions apply. Need a hiring hero? This is a job for Indeed sponsored jobs. The stock is what it is, right? The stock's only value is monetary. And so if the value of the stock goes up, then I'm going to regret selling it to you. And if it goes down, you're going to regret buying it from me. And so it's not that these jobs aren't important. They're incredibly important. the question is how much of this do you need before you're diverting energy that could be going into creating value and spending it all in distributing value.

11:22Distributing is important some of it has to be done capital has to get to the place where it's most productive but surely in the end of the day right when you're in the financial sector the way you create wealth is by helping other people create wealth right it's hard to imagine how you create value create wealth by moving numbers from one cell of a spreadsheet to another sell on a spreadsheet. We can tell stories about a more efficient allocation of capital, and to some extent they're true, but Justin, you and I both, you wrote the wonderful book, The Myth of the Rational Market. I look at the last 25 years of American history, it's really hard for me to make the argument that capital is being allocated all that efficiently between the internet bubble and the mortgage bubble.

12:00That doesn't seem to me like a really powerful story of efficient capital allocation. So yeah, that can help a little bit, but at the end of the day, the person who creates value is the person at Google or Boeing or Tesla or Apple who creates new products and in finance your job is to make it easier for them to do that. But if the wealth, if the financial returns, if the profits all are going to the middleman, to the intermediary instead of the people who are actually doing it, that suggests to me that we've got a problem.

12:29Gautam Mukunda:How do you know what the right size for the financial sector is? Well you don't. I'm sorry. There's no right size. We believe in free markets. I believe in free markets. My argument is that you can absolutely think that deregulation in general is a good idea and that deregulation of the financial sector is a bad idea. That we need to split out because we're treating lots of different things like they're the same thing and that's a problem. We're conflating different types of things. Financial markets are profoundly different in a lot of different ways from other types of markets and so we should treat them differently.

13:04So I don't know what the ideal right size of the financial sector is. No one can do that. I'm not sure that any, right, I'm not even sure that the concept exists. But I can tell you that looking at what we have now, it seems way too large, right? Before the financial crisis, I think the number was something like 40 % of corporate profits in the United States were going to people in the financial sector. I think almost anybody would look at that and say, hmm, that seems deeply problematic. Now, one of the things we could do is, right, is we could do a lot of things to try and crash-proof the financial sector, which would have as a secondary effect shrinking the sector.

13:38And so all of the proposals that I suggested in the article, I said, so all of these proposals will make the sector smaller and less profitable. But take that aside. You know, set that aside. But even if you don't agree with me that that's a good idea, I think I could make the case to you that every single proposal I made is a good idea in and of itself. It's a free win. And so my pitch is only if what we should do is we want to know what the right size of the financial sector is. Well, I don't know. But what we can do is go and eliminate all of the distortions that its power is imposing on the rest of the economy.

14:10In the consequence of doing that, we will make it smaller. Once those distortions are gone, then maybe it will be a little bit too big. I don't know, but the difference will be small enough that I don't really care anymore. Right? We'll all have much more important problems to worry about than that.

14:25Gautam Mukunda:What are the most important distortions that you think it's causing? Okay, so the first one is a fairly straightforward capture of value, which is the very large subsidies that the largest banks are capturing from the federal government. So basically what happens is the banks have an enormous implicit guarantee from the government that if they go under, they're going to get bailed out. Right now, anybody can say, well, we're not going to do that, but that's not credible. We saw what happened last time. If they went under, we bailed them out. And so what that means is the banks can borrow money.

14:58Much large banks can borrow money.

15:24Gautam Mukunda:Get ready for whatever's next. Visit your nearest Croc store today. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsored Jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills, certifications, and more. Spend less time searching and more time actually interviewing candidates who check all your boxes. Listeners of this show will get a$75 sponsored job credit at Indeed.com slash podcast. That's Indeed.com slash podcast. Terms and conditions apply. Need a hiring hero? This is a job for Indeed Sponsored Jobs.

15:59...money much more cheaply than small banks, right? So one is we've created an incredibly perverse incentive here. We're actually paying you to create an institution that is dangerous to the rest of society. That seems like a really bad idea, right? So that incentive all by itself. So if, and the problem is the only way to remove that incentive is to make sure that no bank gets gets so big that it is too big to fail. Because, you're right, the president cannot, there's no way for the president to tie his hands and say, gee, whatever happens, well, I'm not going to bail out. You know, the bank crashes and we get a Great Depression, I'm still not going to bail out.

16:31Nobody will believe you if you say that. So what we have to say is, as the whole line, too big to fail is too big to exist. And, of course, this is how the American economy functioned up until the 1980s. There's nothing revolutionary about that. I'm not proposing, I would say in a real sense that if conservatism is, right, saying that the past has a lot of things to teach us. What I'm saying is in many ways the most conservative thing I could possibly say. The past has a lot of things to teach us. We should learn from the way the system works so we can make the banks smaller. A second proposal I've suggested, that again would be a fairly straightforward one, is that we think that excessive volatility in capital markets can be quite dangerous, right?

17:06That it can be sort of bouncing around and we've seen the markets become more volatile over time. And that it can be dangerous in a lot of ways. One is it sort of increases risk, it increases is the chance of crashes. But it also just incentivizes incentives to think of their financial investments as speculative instead of investment. Where instead of giving money to a company in the hope that the company will go off and create more value, we're buying stock in the hope that somebody else will buy the stock from us at a higher price. Those are profoundly different ways of looking at the world.

17:33And so what I just suggest is a Tobin tax on financial transactions. This was a type of tax proposed first by John Maynard Keynes and then by the economist James Tobin, both of whom, of course, won the Nobel Prize in economics. tax. Just saying that every time you make a financial transaction you should pay a very small tax. I mean a really small tax. And all this does is incentivize people to think about, to sort of make investments for the longer term so they're not making many, many, many trades. And it eliminates lots of actions that have, generate lots of profits. The classic is the high frequency trading that Michael Lewis has critiqued recently, but other things too.

18:05So they generate lots of profits but they don't generate economic value. Another example that I've suggested is a two-part. Essentially, right now, the American government heavily subsidizes debt in preference of equity. So if you're a company and you take out debt, the interest payments are tax deductible. But, of course, if you have equity and your dividend payments are not, and the United States is one of the highest corporate tax rates in the world, the combination means that we're highly incentivizing companies to go into debt. This is great for the financial sector because, after all, they're the ones issuing the debt.

18:37And it's great for the financial sector, second way, right? Because the more debt that's been issued, the more control you're giving up to your bankers over how you run the company. The people who are loaning you the money start to have power over you as well. And in some sense, right, there's no particular reason that we should subsidize debt in preference of equity. In fact, you could make the argument that we should do the opposite. Equity can be a lot healthier than debt can. Debt crises, so if you look at the difference between the internet bubble crash and the mortgage bubble. The internet bubble crashed, it didn't have nearly the same catastrophic effects that the mortgage one did.

19:09And the difference seems to revolve in large part about the difference between debt and equity. The equity crises are a lot less dangerous than debt ones. So why subsidize debt? Why not just eliminate the tax preference for debt in the tax code? This would do lots of useful things. And the final one would be capital gains. So the logic of cutting taxes on capital gains versus taxes on ordinary income is that we're incentivizing people to invest more. So that's a good logic in theory. The problem is the empirics don't support it, right? There's not actually a relationship between lowering taxes and higher, lowering capital gains taxes and higher economic growth.

19:45So you just ask the question, right? Why do we think that a soldier or a doctor or a scientist should pay a tax rate that could be more than twice as high as that of someone who makes their money by investing in stocks? On.

20:00Gautam Mukunda:Hey, Chicago. Class it up with Crocs. You know back to school is coming in fast. So why wait to find your new fave footwear? Step into a local Crocs store and step into your new look. Try it. Style it. Make it yours. Because the right pair doesn't just show up. It shows off. First day fits, handled. Walk out ready for whatever's next. Visit your nearest Crocs store today. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsored Jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills, certifications and more. Spend less time searching and more time actually interviewing candidates who check all your boxes.

20:46Listeners of this show will get a$75 sponsored job credit at Indeed.com slash podcast. That's Indeed.com slash podcast. Terms and conditions apply. Need a hiring hero? this is a job for Indeed Sponsored Jobs. At its face, that doesn't seem like a great argument to be made unless there's some larger economic value from it. And since there isn't, that's a preference that we're giving to a particular sector of society that it is able to extract because of its power. If we take that away, we both eliminate the distortion of the economy and we shrink some of that power. So we get two wins for the price of one.