GEORGE SHULTZ, Thomas W. and Susan B. Ford Distinguished Fellow, Hoover Institution: Oh, here are a lot of memories.
PAUL SOLMAN: George Shultz in a Stanford University conference room awash in memorabilia.
GEORGE SHULTZ: There’s a picture of us meeting with President Obama in the Oval Office.
PAUL SOLMAN: Elder statesmen, classically trained economist.
GEORGE SHULTZ: This is an early edition of Adam Smith’s “Wealth of Nations.”
PAUL SOLMAN: Oh, my goodness.
The conservative Shultz doesn’t go back that far, but he served Republican presidents from the ’50s to the ’80s.
GEORGE SHULTZ: President Reagan was my favorite. The thing about President Reagan was, he was comfortable with himself.
PAUL SOLMAN: Now 89, Shultz is a distinguished fellow at Stanford’s Hoover Institution, where, of late, he’s been pondering the problem of banks deemed too big to fail. A recent quote, “If they’re too big to fail, make them smaller,” he said.
We wanted to know more.
What’s the basic problem, as you see it, with financial institutions at this point in time?
GEORGE SHULTZ: In the first place, if somebody, it’s known they will be bailed out, well, they — they do excessive risk, because they’re doing it on the taxpayer’s dollar. The whole system is badly damaged when bailouts occur.
It takes all of the accountability out of the system. And the market system depends on accountability. So, we have to design a system so anybody in it can fail.
PAUL SOLMAN: Now, did you run into this in your — some of your past lives, or is this — this a new phenomenon?
GEORGE SHULTZ: Oh, no. This is something that you see in a lot of settings. And I have run into the same problem before. In along about August or so of 1968, a strike of the longshoremen starts on the Eastern Gulf Coast. President Johnson thinks that will create a national emergency. He adjourns the strike.
That decision is appealed to the Supreme Court. It’s a fast track in the law. The Supreme Court agrees with the president. So, the strike is stopped. And it starts in again somewhere around January 16 or something of 1969.
PAUL SOLMAN: Less than a week later, Shultz was sworn in as President Nixon’s secretary of labor.
GEORGE SHULTZ: So, I went to the president. And I said to him, Mr. President, your predecessor was wrong, and the Supreme Court was wrong. This strike will create a lot of mumbling around, but it will not be a nationality emergency. And, if you stay out of it, you teach people a big lesson, that they have to take responsibility for themselves.
So, he hung in. And we did get it settled.
PAUL SOLMAN: The following year, as the first director of the Office of Management and Budget, Shultz faced an even bigger crisis. The failure of the Penn Central Railroad.
GEORGE SHULTZ: They deserved to fail. They had mismanaged their affairs. And Arthur Burns was chairman of the Federal Reserve Board. And he was very upset that, if they failed, it would have a bad effect on the financial system, so bad that he had somehow arranged — I never could understand how — a bailout, a massive amount of money for those days, to bail them out.
PAUL SOLMAN: Bail out the Penn Central?
GEORGE SHULTZ: Bail out the Penn Central. So, I think this is a lousy idea. I’m arguing with Arthur Burns. And half of me is saying to myself, what am I doing arguing with Arthur Burns about the financial system? He knows more about it than I do.
And, in that moment, a man named Brice Hallow walked in. And he said, Mr. President, the Penn Central, in its infinite wisdom, has just hired your old law firm to represent them in this matter. Under the circumstances, you can’t touch this with a 10-foot pole, so no bailout. Penn Central failed. No dominoes fell.
PAUL SOLMAN: Did they think at the time that they might have been bailed out by the government?
GEORGE SHULTZ: Oh, yes, I’m sure they did.
PAUL SOLMAN: OK. So we have the longshoremen’s strike. We have got Penn Central, plenty of examples. Bring us to the present. Why did everyone then presume that financial institutions were going to be bailed out when this current crisis started to happen?
GEORGE SHULTZ: Well, you have to ask the people who were participants questions like that. But, for me, sitting back, it didn’t seem to me that they had any sense of a strategy of what they were doing, and thereby letting people know in financial markets how they were going to be behave and how are they going to react to things.
PAUL SOLMAN: But, once they’re confronted with the terror of a frozen, locked market, where nobody will lend to anybody else, and my credit card might not work going down to the store, well, they’re afraid that that will happen throughout the economy. And then they felt they had to do something, no?
GEORGE SHULTZ: Well, I think, if you look at the kinds of indicators that people try to judge panic by, it spreads and things like that, what you see is that it was after the secretary of Treasury and chairman of the Fed went before the Congress and said, the sky is falling, we need $700 billion, and we’re not too clear on just what we’re going to use it for.
Here are the guys in charge, and they — they think the sky is falling. I don’t think it’s a good idea to say things like that. It’s a good idea to keep the sky from falling in the first place.
PAUL SOLMAN: Do you think that large financial institutions that are now deemed to be too big to fail should be, if nothing else can be done, broken up?
GEORGE SHULTZ: No. I think you should ask yourself, what is it about their bigness that causes the problem? And how can we improve matters?
PAUL SOLMAN: So, how can we?
GEORGE SHULTZ: Well, number one, study what you mean by the risk you would find intolerable. Number two, figure out how you’re going to do something about that risk if it materializes.
Number three, take a lesson from people who make Christmas tree lights.
PAUL SOLMAN: Christmas tree lights?
GEORGE SHULTZ: It used to be that the lights you string on a Christmas tree were of such a nature that, if one went out, they all went out, and the longer the string, the harder it was to identify the bulb that went out, so the harder it was to fix it.
So, if you have all of these fancy financial instruments, securitizing mortgages, derivatives of all kinds, you have put all this in the pot, you are in effect making the Christmas tree light longer and longer and longer.
So, why can’t we do what the Christmas tree light manufacturers do? That is, disaggregate these things, delink them. Maybe I have a business and I have a lot of parts of it, but they all don’t have to be arranged in such a way that I’m liable for everything.
PAUL SOLMAN: Serial wiring, I think, it was called.
GEORGE SHULTZ: Yes.
So, I can have a subsidiary that has a limited recourse to me or no recourse to me.
PAUL SOLMAN: You mean it can’t draw on your money…
GEORGE SHULTZ: Exactly.
PAUL SOLMAN: … if it gets into trouble.
GEORGE SHULTZ: And I advertise that. And here’s this unit that is going to do credit default swaps. And, yes, I’m running it. But it’s a stand-alone operation. And everybody who takes part should know that.
PAUL SOLMAN: So, if AIG has the Financial Products division, that has no claim on the insurance company AIG?
GEORGE SHULTZ: You got it.
Then I think you have to say to yourself, why do organizations get big? Because they get advantages out of that. But there’s also more social risk to that bigness. So, we’re going to impose capital requirements and leverage requirements on your operations that are more severe than for a small guy.
PAUL SOLMAN: The more money you’re going to have to set aside in case something bad happens, capital requirements…
GEORGE SHULTZ: Exactly.
PAUL SOLMAN: … leverage requirements, you can’t borrow too much multiple of what you have got?
GEORGE SHULTZ: There’s an underlying principle here that had got lost sight of. And that’s the importance of skin in the game. When you have some of your own money involved, you pay a lot more attention.
PAUL SOLMAN: George Shultz, thank you very much.
GEORGE SHULTZ: Thank you.