Principles of Financial Regulation with Lawrence H. Summers of Harvard University

Secretary of the Treasury. Director of the National Economic Council. President of Harvard University. Washington Post columnist. Economist Larry Summers has held some of the most prestigious roles in public life. Across them all, Dr. Summers has brought an unflinching commitment to incisive observations, even when they cut against the grain.

On the major global macroeconomic issues of our time, Summers’ views aren’t always the popular ones, but they are not easily dismissed. 

Summer’s leadership in the Obama White House in the aftermath of the 2007-2008 financial crisis gives him special insight into the importance of effective regulation of financial markets. Understanding how policymakers should regulate stablecoins was the subject of a fireside chat between Jeremy Allaire and Larry Summers this past September at Converge22, Circle’s inaugural ecosystem summit. (Dr. Summers was compensated for his appearance at Converge22.)

Host: Please welcome Jeremy Alair and Dr. Summers.

Jeremy: Okay, I want to pivot a little bit to a little bit closer to home in terms of stable coins regulation. As we were talking just before we got up here. As you know, there's intensive work happening as we speak on Capitol Hill with legislation payment stablecoin act. 

There's sort of a real prospect of federal regulation over this particular part of the digital asset ecosystem and what that represents. Maybe first before commenting on that specifically, you've been very involved in financial regulation over decades and have sort of seen what works, what hasn't worked. Maybe just first, just some general lessons that you think if you're talking to, whether it be lawmakers or helping people here, think about what kind of is it a soft touch, what kind of touch is it on a nascent technology such as this?

Larry: So I suggest maybe three principles. First, I think there's a lesson from a very different sphere, which is automobile safety. We discovered in America in the 1950s that auto accidents were a huge problem. There was like a fifth as much driving as there is now, and 40 or 50,000 Americans were getting killed each year. 

And the original approach was lots of emphasis on driver's ed and then people realized that you could try it. Maybe it did some good, but it was basically better to assume that people weren't going to be perfect and to make it so windshields didn't send fragments of glass and put seatbelts in cars and put airbags in cars and put safety rails on highways and have policemen give breathalyzers to people. And that you needed an approach that wasn't just about calling for the perfectibility of man. And I think that's a broad lesson in financial regulation. 

A second lesson is that we need a system that is as modern as the markets. And one of the problems always is that the markets move fast and evolve quickly and politics moves slow and moves deliberately. And so that would be the kind of second lesson. And I think the third lesson is that storms come and good enough for good times isn't good enough, and that you need a system that is robust to bad outcomes or else bad outcomes will become a self fulfilling prophecy. That you need a system that is modern with respect to new things and you need a system that doesn't rely on everybody being virtuous if it is to succeed. And I guess the other last thing I would say is generals have a huge tendency to fight the last war and regulators have a huge tendency to respond to the last problem. And I think that is not the way we want to approach this. 

And I guess I would make one last lesson, which I guess I would say to my friends in industry, be careful what you wish for. Regulation often is resisted by industry and then often becomes a substantial enabler for industry. A bunch of the reason why the New York Stock Exchange has been as large in capital markets for as long as it has been has been precisely the strength US. Regulation. So I think proper regulation is something that is essential to a healthy financial system. But both those words were important, the word proper and the word regulation.

Jeremy: Okay, there's a lot of wisdom there, maybe getting specifically sort of what's in front of us. Like a year ago, FSOC, all the leaders of FSOC issued a report saying it's urgent that Congress act to have legislation around stable coins. There could be run risks, there could be exposure over time systemically to the real economy. It's obviously not there. We certainly saw a stablecoin collapse earlier this year. It did not affect the general economy, but it took maybe a trillion dollars out of the crypto economy, one could potentially argue. And now regulators are responding to the most recent thing in some respects and there's more urgency on this today, but it's getting to some other issues, which is sort of the establishment of dollar payment system models that are operated by non banks. 

I know you're on the board of Block or Square and you've seen payment system innovation in the space and sort of that kind of activity. And there's sort of this interesting question of is there a path for the private sector and for non banks as well as banks to be regulated in this kind of space?

Larry: Look, I have a pretty strong view that lots of people who've spent their whole lives in financial regulation probably don't like, which is that we overly fetishize the bank non bank distinction. I think in many ways that was central to why we had the 2008 financial crisis. We had these institutions called banks and we regulated them really heavily and then we had this theory that there were non banks and we would just let them fail so we didn't need to regulate them, but then we really couldn't tolerate having them fail. See Bear Stearns, See Lehman, See AIG, See Countrywide, See Fannie Mae and so the whole thing sort of didn't work. And we had this circle of very heavily regulated institutions that we didn't actually do such a fantastic job of keeping them safe. But then we had these other institutions who we said were going to fail and so we didn't pay attention to their capital much at all or their liquidity much at all. And then that brought on a mess. 

And so I think the idea of saying that you have to be a bank and live with all the things that banks live with and be heavily regulated and get your access to the Fed or else you're off in the wild and we assume you'll fail if you screw up and that nothing bad will happen. I think that's a bad system for everybody. I think it's a system that will stifle innovation by limiting competition in the new technologies because not as many people will be able to do them. I think it's a system that will increase systemic risk because it will leave a lot of stuff outside the circle of regulation. And I think it's a system that will ultimately probably not benefit the banks because there'll be a tendency for the activity to find their way out of the banks and into the shadows of the unregulated shadow system. 

So I think we are better off in a way that recognizes a more variable ecology of different institutions with different missions that are regulated in different ways, rather than having this stark two category system that then gets pushed in the margins in various ways through industrial loan companies and the like. That would be my broad sort of philosophical view on the question, Jeremy.

Jeremy: That's helpful. I think we're seeing sort of proposals that are saying we're going to have sufficient and strong regulation around addressing those very big tail risks. So a little bit heavier than the non Bank World but also allowing the functional form of innovation like a dollar stablecoin to happen without having to necessarily be part of a fractional reserve lending operation. I think what you're describing…

Larry: That's exactly the point I was trying to make! That it seems to me that you don't want to have stable coins without making sure they've got stable backing.

Jeremy: Right?

Larry: But if you insist on the only people who can do stable coins being people who are banks and treated as banks, you're going to slow down the process of innovation in all sorts of ways that you probably wouldn't want to slow down the process of innovations. So it seems to me you need to recognize more different kinds of institutions as legitimate. And it seems to me that we need to pay very careful and disproportionate attention to systemic risk issues and making sure that things can't have systemic risk issues rather than sort of regulation around helping institutions run better. 

Too often I have heard supervisors of a given institution use the term “we” and that always makes me wince. And too often I have thought we need to make sure we have systems that don't rely on the idea that supervisors are going to be smarter than management, because I think it's unlikely, given government wages and financial sector wages, that it's systematically true that that's likely to be what takes place.

Jeremy: That all makes sense. I want to kind of build off of the start of the conversation and the second piece and sort of just sort of say, hey, we're looking at a world where dollar based digital currency models right now that's sort of built on these open public infrastructures like blockchains and private sector issuers like Circle. 

Maybe a regulatory framework around that. But coming back to the strength of the dollar and the competitiveness of the dollar, in a sense, what we're seeing is a kind of upgrading of the technology of the dollar, the form factor of the dollar, the functionality of the dollar. And all of a sudden, the dollar in this digital form can kind of float and connect everywhere that the internet connects. And I'm interested in your take on what that does to geopolitical geoeconomic considerations around this kind of proliferation of internet money and what challenges that might pose for not just the United States but for other governments.

Larry: It's kind of a profound question, Jeremy. I think we get a lot of advantages in the United States from the fact that we speak the English language. And the English language has become the broad language of dialogue. No country in the EU speaks English, but when they have an EU meeting, it's usually in English. And that is something that's very helpful to the United States.

And the fact that everybody likes watching the NBA and the NBA sort of happens in English, the fact that everybody likes using the internet and the internet happens in English, I think all of that operates to strengthen us. And I think the dollar is kind of like English, and it has the same kind of broad benefits as networks. And anything that happens that makes the dollar work better strengthens the soft power of the United States and helps us pursue all of our various national objectives. 

So it seems to me that it can only help us; help us in terms of senior age, but even more help us in terms of our broad national influence. If the best systems for transferring value across countries are based around the dollar in the same way that it helps us if little kids in rural Indonesia are beginning to learn to speak English rather than beginning to learn to speak Dutch or French, that's good for us. And I think the same thing is true. So I don't think we should try at all to stop other countries from developing their payments systems as well as they can. But I think we have a first mover advantage, and we need to make sure as we regulate and develop our financial system that we don't do anything to compromise that first mover advantage.

Jeremy: Here here. I think it's fascinating time for markets, for technology, regulation, the dollar. We're really privileged to have you here to talk about all this today. So let's please give a warm thanks to Larry Summers.

Jeremy Allaire
Co-Founder, CEO & Chairman at Circle
Lawrence H. Summers
President Emeritus, Harvard University

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