Recently, at a dazzling speed, we are witnessing a historic shift in the world economy. Literally, in front of our eyes, an era that was dominated big financial institutions in Wall Street is coming to an end. At a breathtaking speed, giants of Wall Streets – Bear Stern, Freddie Mac, Fennie Mae, Lehman Brothers, Merill Lynch and AIG –, once most coveted places to work for newly minted MBA students, are gone. That is not the end of the story. Goldman Sachs and Morgan Stanley decided to become a commercial bank. And the failure of financial institutions are quickly moving beyond the banks in Wall Street. Washington Mutual and Wachovia were also sold at the fire sale price. With trillions dollars of toxic debts spread in the complex web of global financial systems, non one seems to know for sure even the $700 billion bailout from the US Treasury will be enough. So the question that everyone is asking is why did this happen and what do we do now?
One way to react to this series of collapses is to blame the sub-prime mortgage lending practice and the greed of few of those executives who made hundreds of millions of dollars while their banks are failing. We can also blame the exotic derivative instruments such collateralized debt obligations (CDO) and credit default swaps (CDS) that these banks used in order to slice and dice the highly leveraged investments. We can further blame the de-regulations that went on since the Reagan administration. After the $700 billion bailout, there will be a barrage of new regulations that restricts the use of reckless investments and excessive executive compensations. All of these criticisms and regulations are valid and should be taken seriously. Yet, they fall short of addressing the real fundamental structural cause of the current historic shift. These responses tend to contemporalize this historic shift, thus missing the opportunity to respond to this structural change with a structural solution.
The current reaction to the problem reminds us what happen immediately after the debacle Enron, WorldCom, and Tyco. After the failure of these companies, the CFO of these firms all went jail. There was a backlash against the apparent greed and deceits by these firms and their executives. The response then was more ethics course in the MBA curriculum and more regulations (e.g, Sarbanes-Oxley). Once we have new ethics courses and new laws in place, we went back to business as usual, except that business was no long as usual.
These two sets of events are symptoms of the same cause. They are two different sides of the same coin, which showed up at different point in time in history. Both have to do with the demise of the industrial economy and subsequent collapse of the intellectual foundation of Wall Street. The collapse of Wall Street does not simply reflect excessive greed and reckless investment by few bankers. Instead, it displays a fundamental re-shaping of underlying industrial economy and how the wealth is created in the economy. Wall Street, which symbolizes the modern financial system, is a derivative of the industrial economy where an entrepreneur who has a good idea create wealth by producing product with more features at a lower cost. In that process, the entrepreneur needs to go to the capital market to gain access to the capital. Financial institutions played a critical role of financial capital aggregator, by channeling the savings and investments from individuals and large institutional investors to potential profitable opportunities. Within this historic context, the modern financial industry gained its dominant position in the industrial economy. Also, inside modern organizations, executives and manager who manage the financial capitals play very important roles.
Financial institutions turn profit from their investment on these firms that produces goods and services that we buy and produce. At least, that was how it worked in the past. Over time, as the fundamental basis of industrial economy in the US is being challenged, the investment to the industrial companies no longer yield enough profit for the financial institutions. The rapid and fundamental demise of industrial firms, epitomized by the chronic struggle of automotive Big-3 in Detroit, in turn made these industrial firms less desirable place to invest financial capital. In fact, over the last decade, General Motors have made more buy through financial investment than through the sales of its cars.
As industrial bases in the US economy weakens and thus, becoming less attractive target for investment, financial institutions had to find better places to invest their capital. This led to speculative investments into commodity and real estate. But, more importantly, financial institutions invented their own investment opportunities by creating exotic “financial products” that are based on dubious abstract model assisted by complex computer models. Unlike original investment options, these financial derivative products have very loose connection, if any, to the production and consumption of physical and material products and services. In a nutshell, these financial institutions decided to investment on themselves, as they run out of attractive investment options elsewhere. These recursive investments on their own inventions, with little or no connection to the real value creation in the material economy, spread like a wild fire among global financial institutions hungry for bigger profit opportunities. However, such recursive investment only creates wealth endogenously, which we simply call bubble. And what we are seeing now is the collapse of the entire financial systems crumbling down on its own weight. Such a system with a closed feedback loop simply cannot be sustained.
The analysis so far suggests that the root cause of the current financial crisis is not at the financial institutions alone. A fundamental challenge we have is that industrial firms can no longer remain competitive and profitable simply through their access to financial capital. Therefore, the departure point of the design of new Wall Street is to create attractive investment opportunities that are based on real wealth creation and real innovations. Furthermore, the design has to be based on the realization that financial capital alone is no longer enough to create value in this post-industrial economy. What firms need is access to “knowledge capital” that can catalyze their innovations. Just like at the beginning of the industrial economy firms needed easy access to large sum of financial capital, firms in this generation need to access large sum of knowledge capital in order to break new grounds and produce new kind of products and services that lift up humanity and inspire next generations. We need firms that will make next Google, new iPod and new source of green energy. Of course, they need large financial capital to succeed. But financial capital alone will not be enough. These firms need knowledge that comes from many different sources, easily accessible.
What we need, then, is a new kind of Wall Street. New Wall Street will consist of banks of knowledge capital. Just like their predecessors in the industrial economy, these new knowledge institutions will act as knowledge capital aggregators. Small individuals and investors can invest their knowledge resources to these new forms of institutions for future return. In turn, these knowledge institutions will look for attractive opportunities to invest large knowledge capital for much larger return. These new knowledge institutions will work in tandem with what remains in the old Wall Street.
Chinese word crisis means both crisis and opportunity. Indeed, every crisis is pregnant with unforeseen opportunities. Here, we are facing monumental crisis – a crisis that stems from a fundamental shift in our economy. Yet, it comes with a new opportunity – an opportunity to design a new Wall Street. With this new opportunity, our response cannot and should not end with a rescue plan to keep the debris from the old Wall Street further falling into abyss and more regulations and new set MBA courses on ethics. We need to reinvigorate the parts of our economy that produces real wealth by making ingenuous and inspiring products and services. Without such changes, we may end up with different kind of derivatives that are based on more sophisticated and complex models, yet even further disconnected with real value creation.