When Your Employees Know More Than You

Managing today's highly skilled professionals takes special skills — and not the ones that you may think. Oftentimes, knowledge workers know more than you do about their jobs. So, how do you manage people who know more about what they do than you do?

In such instances, you have to look at leadership through the wants and needs of the worker as opposed to the skills of the leader. Here are some quick tips for effectively managing knowledge workers.

Demonstrate passion
In days past, working 40 hours per week and taking 4-5 weeks of vacation meant that people often focused less on loving what they do. Today people work 60-80 hours a week and it's crucial that they love their work to avoid burnout. Those who lead by example and demonstrate passion for what they do make it much easier for their followers to do the same.

Strengthen abilities
With less job security and more global competition, it's critical that people update and refine their skills continuously. Leaders need to look beyond skills needed today and help their workers learn skills they will need tomorrow.

Appreciate time
People have less time today, which means the value of that time has increased. Leaders who waste their workers' time are not looked upon favorably. Leaders will be far more successful if they protect people from things that neither encourage their passions nor enhance their abilities.

Build networks
Today, job security comes from having ability, passion, and a great network. Leaders who enable people to form strong networks both inside and outside the company will gain a huge competitive advantage along with the loyalty of their workers. These professional networks allow people to expand their knowledge and bring it back to the organization.

Support growth
The best knowledge workers are working for more than money. They want to make a contribution and to grow in their fields. Leaders who ask their people, "What can our company do to help you grow and achieve your goals?" will find it comes back tenfold.

Expand happiness and meaning
No one wants to work at a meaningless job that makes them unhappy. Leaders must show their workers how the organization can help them make a contribution to the larger world and feel rewarded for doing something about which they are passionate.

Managing knowledge workers is a challenging and rewarding job. Leaders who do so must look beyond the work and think about the person who does the work if they are to be successful. By appreciating and encouraging the dedication, time, and experience of their workers, leaders help shape not only the futures of the professionals they lead but also the future of their organizations.

Copyright © 2010 Harvard Business School Publishing. All rights reserved. Harvard Business Publishing is an affiliate of Harvard Business School.

Learn to Embrace the Tension of Diversity

As leaders, the rich diversity of culture and thought around the world is one of our greatest resources — if we use it as such. Differences of ideas, methods, motivations, and competencies can be used to build great organizations. However, this wonderful resource can be a double-edge sword as cross-cultural exchanges present unlimited possibilities for misunderstandings and cultural blunders.

As companies grow and expand around the world, diversity in the workplace increases. Successful organizations identify, recruit, and train professionals from a diverse blend of backgrounds, cultures, styles, and motivations into positions of increasing power and responsibility.

In the midst of individual contributors with such diverse backgrounds, success calls for leaders who are comfortable with diversity tension. Diversity tension is the stress and strain that accompanies mixtures of differences and similarities. The task of leaders working in the global business arena is not to minimize this tension, but rather to use it as a creative force for change, and, of course, to make quality decisions in the midst of identity differences, similarities, and pressures.

Leaders who prepare and empower their employees to understand others without judging, to be requirement-driven, and to be comfortable with diversity tension are more productive and successful. It just isn't enough for leaders to possess these capabilities themselves; they must also develop them throughout the organization.

What are some good first steps to developing positive diversity tension in the workplace? Well, one is to not make any assumptions about the cultural base or outlook with whom you work or do business. Another is to understand the dynamics of diversity (through historical, political, and economic references), how it affects the workplace, worldviews, life and communication styles, ethics, and etiquette of co-workers.

Developing positive diversity tension takes an understanding of both the big things and the small things that form unique cultures, including leadership and work styles (for instance formal vs. informal); decision-making styles (e.g. intuitive vs. analytical); information-sharing methods (do people prefer written, oral, face-to-face, text, email, video conference, etc.); and motivations (these could be power, achievement, affiliation, money, etc.). It's not necessary to hold everyone's views on these matters, but it is important to accept that there are many different methods, positions, and styles by which people can accomplish goals and directives.

Utilizing diversity tension in the workforce requires that leaders understand that differences in race, culture, and background are advantages — not deficits — for effective teamwork and problem solving.

To take embrace diversity tension, leaders need to:

• Create an inclusive work environment where people feel welcomed and valued for sharing their opinions and skills
• Recognize and reward successes that result from valuing diversity
• Assess the different learning styles and strengths in people
• Involve people from a variety of backgrounds in decision-making and problem-solving processes
• Utilize the full potential of all employees and build on complementary skills, backgrounds, and cultural knowledge
• Refuse to accept behaviors that attack the self-respect of others and confront people who stereotype others or display prejudiced behavior
• Participate in diversity training
• Involve a wide variety of people in their personal and professional lives, and take the time to get to know them

Using tension of diversity as a positive, rather than viewing differences as negative, a well-rounded diverse team will be able to produce valuable brainstorming sessions, imaginative problem-solving and decision making, unique perspectives on strategic planning, and inventive product development ideas. The benefits of such a diverse workforce will be felt throughout the organization and are key to competing successfully in the global marketplace.

Copyright © 2010 Harvard Business School Publishing. All rights reserved. Harvard Business Publishing is an affiliate of Harvard Business School.

How to Face Your Critics

When people criticize you, what's the best thing to do? Show up and face the music.

President Barack Obama did just that when he met with Republican House members at their party conference last week in Baltimore. He met face-to-face with some of his sharpest critics, and in the process, demonstrated what it means to lead under fire.

In doing so, the President, whether you like or dislike him, provided a template for leaders to use when they need to face critics. Here's what we can learn.

Show up. Let your critics see you for the leader who you are. Adopting a "hide in the bunker" attitude only plays to them. It gives them free rein to paint you however they like — demon, demagogue, or do-nothing. By showing up you demonstrate that you are not afraid.

Be open. President Obama invited the media; you can shoot video of your meeting and broadcast it over a controlled-access website. In doing so, you demonstrate transparency and show your willingness to engage those who disagree with you. Videotaping also challenges people to be on their best behavior because they are being recorded.

Be cool. When people criticize you to your face, breathe deeply. As an opponent's voice rises, lower yours. Speak deliberately and with a sense of calm. The more control you have of your emotions, the stronger you will appear.

Acknowledge your shortcomings. Standing up to criticism is an opportunity to admit your own failings. Do it with a sense of earnestness, that is, demonstrate through words and passion that you have done what you think is best. At the same time, do not be defensive. Act with honest confidence, even when you admit mistakes.

Criticize gently. The spotlight may be on you, but the heat is also on your critics. Give as good as you get, but do it with a sense of diplomacy. A good-natured jibe here or there is good for you as well as others. It reveals your humanity.

Smile frequently. Lighten things up by relaxing your facial muscles. This demonstrates that you are in control. Smile when appropriate, but never smirk. Don't let them see you sweat, either. Smiling keeps you on a more even keel.

Leave them wanting more. Know when to close the engagement. You can ruin a good thing by hanging around on stage. It may be appropriate to meet and mingle off stage, in fact that's a great idea, but know when to get off the stage and let others talk.

When the heat is on, showing your face to your sharpest critics is a great way to demonstrate that you are in control of yourself as well as your message. Standing up to those who oppose you is a strong measure of demonstrating that you have what it takes to lead.

Copyright © 2010 Harvard Business School Publishing. All rights reserved. Harvard Business Publishing is an affiliate of Harvard Business School.

Classic case of Triangulation

Thomas Friedman's on the current state of Israel-Palestinian Peace process.


If you think this latest Israeli-American flap was just the same-old-same-old tiff over settlements, then you’re clearly not paying attention — which is how I’d describe a lot of Israelis, Arabs and American Jews today.

This tiff actually reflects a tectonic shift that has taken place beneath the surface of Israel-U.S. relations. I’d summarize it like this: In the last decade, the Israeli-Palestinian peace process — for Israel — has gone from being a necessity to a hobby. And in the last decade, the Israeli-Palestinian peace process — for America — has gone from being a hobby to a necessity. Therein lies the problem.

The collapse of the Oslo peace process, combined with the unilateral Israeli pullouts from Lebanon and Gaza — which were followed not by peace but by rocket attacks by Hezbollah and Hamas on Israel — decimated Israel’s peace camp and the political parties aligned with it.

At the same time, Israel’s erecting of a wall around the West Bank to prevent Palestinian suicide bombers from entering Israel (there have been no successful attacks since 2006), along with the rise of the high-tech industry in Israel — which does a great deal of business digitally and over the Internet and is largely impervious to the day-to-day conflict — has meant that even without peace, Israel can enjoy a very peaceful existence and a rising standard of living.

To put it another way, the collapse of the peace process, combined with the rise of the wall, combined with the rise of the Web, has made peacemaking with Palestinians much less of a necessity for Israel and much more of a hobby. Consciously or unconsciously, a lot more Israelis seem to believe they really can have it all: a Jewish state, a democratic state and a state in all of the Land of Israel, including the West Bank — and peace.

Why not? Newsweek’s Dan Ephron wrote in the Jan. 11, 2010, issue: “An improved security situation, a feeling that acceptance by Arabs no longer matters much, and a growing disaffection from politics generally have, for many Israelis, called into question the basic calculus that has driven the peace process. Instead of pining for peace, they’re now asking: who needs it? ... Tourism hit a 10-year high in 2008. Astonishingly, the I.M.F. projected recently that Israel’s G.D.P. will grow faster in 2010 than that of most other developed countries. In short, Israelis are enjoying a peace dividend without a peace agreement.”

Now, in the same time period, America went from having only a small symbolic number of soldiers in the Middle East to running two wars there — in Iraq and Afghanistan — as well as a global struggle against violent Muslim extremists. With U.S. soldiers literally walking the Arab street — and, therefore, more in need than ever of Muslim good will to protect themselves and defeat Muslim extremists — Israeli-Palestinian peace has gone from being a post-cold-war hobby of U.S. diplomats to being a necessity.

Both Vice President Joe Biden and Gen. David Petraeus have been quoted recently as saying that the festering Israeli-Palestinian conflict foments anti-U.S. sentiments, because of the perception that America usually sides with Israel, and these sentiments are exploited by Al Qaeda, Hamas, Hezbollah and Iran to generate anti-Americanism that complicates life for our soldiers in the region. I wouldn’t exaggerate this, but I would not dismiss it either.

The issue that should make peacemaking a necessity rather than a hobby for both the U.S. and Israel is confronting a nuclear Iran. Unfortunately, Israel sees the question of preventing Iran from going nuclear as overriding and separate from the Palestinian issue, while the U.S. sees them as integrated. At a time when the U.S. is trying to galvanize a global coalition to confront Iran, at a time when Iran uses the ongoing Palestinian-Israeli conflict to embarrass pro-U.S. Arabs and extend its influence across the Muslim world, peace would be a strategic asset for America and Israel.

Ari Shavit, a columnist for the Israeli daily Haaretz, last week argued that Israel should adopt a more integrated view — which he calls a “Palestine-Iran-Palestine” strategy: Israel should take the initiative with an overture to the Palestinians, which would make progress on that front easier, which would strengthen the U.S. coalition against Iran, which could ultimately weaken Tehran and its allies, Hamas and Hezbollah, which would open the way for more progress on the Palestine-Israel front. He suggests that Israel reach an interim agreement with Palestinians on the West Bank or even consider a partial, unilateral withdrawal there.

“One way or another,” said Shavit, “Netanyahu should have made a genuine move on the Palestinian front that would have made genuine moves on the Iranian front possible, that would have made dealing with the core of the Israeli-Palestinian dispute possible at a later stage.”

Indeed, Jerusalem, settlements, peace, Iran — they’re all connected and pretending you can treat some as a hobby and one as a necessity is an illusion.

The Lords of Strategy

Book review by WSJ

As a business journalist and former editorial director of the Harvard Business Review, Walter Kiechel has had the unenviable task of spending much of his life hanging around with management theorists. These are the folks who bring out book after book of business advice that readers find unreadable and managers find unmanageable. Yet by some miracle Mr. Kiechel has remained immune to the maladies of the genre. His "The Lords of Strategy" is a clear, deft and cogent portrait of what the author calls the most powerful business idea of the past half-century: the realization that corporate leaders needed to abandon their go-it-alone focus on their company's fortunes and instead pursue policies based on a detailed study of the competitive environment and of broader business trends.

The "strategy revolution" began in the 1960s when the Boston Consulting Group upended the industry. Rather than take the usual tack of just cozying up to individual chief executives for a bit of corporate kibitzing and calling it consulting, BCG produced a series of elegant intellectual models that could be broadly applied across the business world. BCG's model for the "experience curve," for instance, taught companies that they could reduce their costs as they expanded their market share, thanks to the accumulation of know-how. The "growth share matrix" encouraged companies to view themselves not as an undifferentiated whole but as a portfolio of businesses that make different contributions to the bottom line ("cash cows" vs. "dogs," for example). Nowadays that sort of thinking might be unexceptional, but it was a radical development in the stagnant, inward-looking world of 1960s corporate America.

The 1970s and the decades that followed saw the institutionalization of the revolution. One of BCG's main competitors, McKinsey & Co., shook itself out of a complacent torpor and began enthusiastically running out its own management-strategy models. Bill Bain and several other BCG executives left the company in the 1970s and started a rival enterprise, Bain & Co. Meanwhile, Michael Porter brought strategy to the heart of the business establishment, the Harvard Business School. He added a powerful tool to the discipline's arsenal, the notion of the "value chain," which helped managers break down a business into its component parts, from raw materials to finished products, and then subject those parts to the rigors of cost-benefit analysis.

Yet success brought intense scrutiny and self-examination. In 1982, Tom Peters and Robert Waterman—McKinsey stars at the time—argued in the best-selling "In Search of Excellence" that the obsession with strategy was leading managers to ignore the human side of things. The year before, Richard Pascale, another McKinseyian, said in "The Art of Japanese Management" that the Japanese, who were then sweeping all before them, regarded the West's newfound passion for strategy as strange, much "as we might regard their enthusiasm for kabuki or sumo wrestling." And an army of young thinkers began shifting attention to more nuts-and-bolts matters, such as business processes (which could be re-engineered) and "core competencies" (which needed to be cultivated).

Today the status of strategic thinking in the business world is somewhat confused: An idea that owed its appeal to the seemingly hard truths presented by models is becoming ever more nebulous. The lords of strategy are now given to happy talk about "people"—on the grounds that people are the key to innovation and innovation is the key to long-term success. Such concerns can easily degenerate into bromides about the need to treat employees well. Perhaps it is no coincidence that, at least before the current financial crisis wreaked its havoc, young business hotshots were turning their attention to financial engineering. About a third of former McKinsey and BCG consultants currently work in the private-equity business.

"The Lords of Strategy" is at its best describing and explaining the evolution of an influential idea in American business. The book is less successful as the "secret history" it claims to be. Mr. Kiechel has the habit of pulling aside the veil on the darker side of the management business only to pull it back again. He says that management gurus are known to hire ghost-writing outfits such as Wordworks to produce their books—but he refrains from telling us the gritty ( perhaps disgraceful) details of the marketing and packaging process. He notes that a worrying number of consulting engagements end in tears—McKinsey had a long-term relationship with Enron, for example—but he skimps on evidence.

Mr. Kiechel makes up for this coyness, though, with his enthusiasm for telling the bigger story at the heart of his book: the intellectualization of business. Back in the days of the "organization man" in the 1950s, business people tended to be affable types—pleasant, easy to get along with, but hardly rocket scientists. Since then an ever greater amount of brain power has been applied to business as more and more graduate students pursue MBAs (150,000 annually in the U.S., up from 3,000 a year in 1948), and the brightest MBAs often go on to become business consultants.

The story that Mr. Kiechel tells does not have a particularly happy ending: The "quants" who would supposedly take business to a new level of intellectual sophistication designed financial tools such as the credit default swap that instead took the world economy to the brink of catastrophe. But Mr. Kiechel is surely right that we cannot begin to understand the world that we live in unless we grasp how corporate intellectuals came to have such a dramatic influence on the business world—and how old-fashioned virtues, such as judgment and common sense, were side-lined in the process.

Fed's Balance sheet

From the WSJ:

FED's Balance sheet as of 16th March 2010

To save US automobile industry don't save GM

It's an old article written by Mitt Romney.

IF General Motors, Ford and Chrysler get the bailout that their chief executives asked for yesterday, you can kiss the American automotive industry goodbye. It won’t go overnight, but its demise will be virtually guaranteed.

Without that bailout, Detroit will need to drastically restructure itself. With it, the automakers will stay the course — the suicidal course of declining market shares, insurmountable labor and retiree burdens, technology atrophy, product inferiority and never-ending job losses. Detroit needs a turnaround, not a check.

I love cars, American cars. I was born in Detroit, the son of an auto chief executive. In 1954, my dad, George Romney, was tapped to run American Motors when its president suddenly died. The company itself was on life support — banks were threatening to deal it a death blow. The stock collapsed. I watched Dad work to turn the company around — and years later at business school, they were still talking about it. From the lessons of that turnaround, and from my own experiences, I have several prescriptions for Detroit’s automakers.

First, their huge disadvantage in costs relative to foreign brands must be eliminated. That means new labor agreements to align pay and benefits to match those of workers at competitors like BMW, Honda, Nissan and Toyota. Furthermore, retiree benefits must be reduced so that the total burden per auto for domestic makers is not higher than that of foreign producers.

That extra burden is estimated to be more than $2,000 per car. Think what that means: Ford, for example, needs to cut $2,000 worth of features and quality out of its Taurus to compete with Toyota’s Avalon. Of course the Avalon feels like a better product — it has $2,000 more put into it. Considering this disadvantage, Detroit has done a remarkable job of designing and engineering its cars. But if this cost penalty persists, any bailout will only delay the inevitable.

Second, management as is must go. New faces should be recruited from unrelated industries — from companies widely respected for excellence in marketing, innovation, creativity and labor relations.

The new management must work with labor leaders to see that the enmity between labor and management comes to an end. This division is a holdover from the early years of the last century, when unions brought workers job security and better wages and benefits. But as Walter Reuther, the former head of the United Automobile Workers, said to my father, “Getting more and more pay for less and less work is a dead-end street.”

You don’t have to look far for industries with unions that went down that road. Companies in the 21st century cannot perpetuate the destructive labor relations of the 20th. This will mean a new direction for the U.A.W., profit sharing or stock grants to all employees and a change in Big Three management culture.

The need for collaboration will mean accepting sanity in salaries and perks. At American Motors, my dad cut his pay and that of his executive team, he bought stock in the company, and he went out to factories to talk to workers directly. Get rid of the planes, the executive dining rooms — all the symbols that breed resentment among the hundreds of thousands who will also be sacrificing to keep the companies afloat.

Investments must be made for the future. No more focus on quarterly earnings or the kind of short-term stock appreciation that means quick riches for executives with options. Manage with an eye on cash flow, balance sheets and long-term appreciation. Invest in truly competitive products and innovative technologies — especially fuel-saving designs — that may not arrive for years. Starving research and development is like eating the seed corn.

Just as important to the future of American carmakers is the sales force. When sales are down, you don’t want to lose the only people who can get them to grow. So don’t fire the best dealers, and don’t crush them with new financial or performance demands they can’t meet.

It is not wrong to ask for government help, but the automakers should come up with a win-win proposition. I believe the federal government should invest substantially more in basic research — on new energy sources, fuel-economy technology, materials science and the like — that will ultimately benefit the automotive industry, along with many others. I believe Washington should raise energy research spending to $20 billion a year, from the $4 billion that is spent today. The research could be done at universities, at research labs and even through public-private collaboration. The federal government should also rectify the imbedded tax penalties that favor foreign carmakers.

But don’t ask Washington to give shareholders and bondholders a free pass — they bet on management and they lost.

The American auto industry is vital to our national interest as an employer and as a hub for manufacturing. A managed bankruptcy may be the only path to the fundamental restructuring the industry needs. It would permit the companies to shed excess labor, pension and real estate costs. The federal government should provide guarantees for post-bankruptcy financing and assure car buyers that their warranties are not at risk.

In a managed bankruptcy, the federal government would propel newly competitive and viable automakers, rather than seal their fate with a bailout check.

The Latest AIG Story: Regulators can't agree on what the real systemic threat was

Will regulators ever coherently explain why AIG could not be allowed to go bankrupt in September of 2008?

At yesterday's House hearing, Secretary of the Treasury Timothy Geithner and predecessor Hank Paulson said they didn't bail out AIG to save its derivatives counterparties. Instead, said Mr. Geithner, the now-famous 100-cents-on-the-dollar buyouts of credit default swap contracts were necessary to prevent a further downgrade of AIG by credit-ratings agencies.

This topic probably deserves another hearing on its own. Remember, the Federal Reserve Bank of New York, where Mr. Geithner was president, had by that time already seized AIG. We're guessing that a ratings agency is pretty comfortable with the creditworthiness of a firm 79.9%-owned by Uncle Sam. Yet Mr. Geithner is saying that the same credit raters that applied triple-A ratings to tranches of junk mortgages somehow got the yips when the world's most respected borrower was standing behind AIG.

If the agencies had applied to AIG the credit rating of its new owner, there wouldn't have been much need to send more collateral to such counterparties as Goldman Sachs. Instead, AIG could have demanded the return of some of the collateral it had already posted. Bad news for those counterparties.

More broadly, the hearing showed that the story of why AIG could not be allowed to fail continues to change, which inspires little confidence that Washington can be trusted with new powers to identify and address systemic risk. The original Beltway line was that the systemic risk was caused by AIG's inability to back up the credit default swap contracts it sold, thus endangering counterparties on the other end of these deals. In Washington's original telling, the company's insurance subsidiaries, heavily regulated by states, were safely segregated from the mess.

Yesterday, however, Messrs. Geithner and Paulson went further than ever in stating that the real systemic risk was to AIG's heavily regulated insurance businesses. Their testimony directly contradicts that offered to Congress by former New York Insurance Superintendent Eric Dinallo, who was AIG's principal insurance regulator at the time.

Last year Mr. Dinallo told the Senate that "The main reason why the federal government decided to rescue AIG was not because of its insurance companies." He was so confident in the health of the AIG subsidiaries that, before the federal bailout, he was working on a plan to transfer $20 billion of their excess reserves to the parent company.

Yesterday, Mr. Geithner said that the "people responsible" for overseeing the insurance subsidiaries "had no idea" about the risks facing AIG policyholders. He's talking about Mr. Dinallo here. Instead of being safely segregated, Mr. Geithner said the insurance businesses were "tightly connected" to the parent company. Mr. Paulson added that the healthy parts of AIG had been "infected" by the "toxic assets." He added, "One part of the company would have contaminated the other."

This raises some serious issues for financial reform. The Geithner and Paulson story now is essentially that the system of heavy state insurance regulation was a sham. When push came to shove, policyholders were not protected from a default by the parent company.

This also makes us wonder about all of the political and media chatter over the last year that derivatives were the doomsday machine that caused the meltdown. If this testimony is correct, then the systemic risk wasn't that if AIG collapsed it would infect Goldman and other financial companies like falling dominoes across the world.

The real risk was closer to an implosion of AIG that would have jeopardized millions of insurance policies. That's a big problem for insurance regulation. But if bad bets on derivatives would only have ruined AIG and its subsidiaries, that's not the same kind of danger to the entire financial system. And it suggests the need for different regulatory changes. We're not sure that policyholders were really in danger, but Mr. Dinallo and other state regulators deserve a chance to respond on the record, and under oath.

If yesterday's testimony is true, the real systemic risk was not in unregulated markets where the danger is obvious, but in markets where regulation created the illusion of safety.

Bernanke Answers Economist's Questions

Several economists submitted the following questions to senator to be asked during the confirmation hearing of Federal Reserve Chairman Ben Bernanke.

A. Anil Kashyap, University of Chicago Booth Graduate School of Business: With the unemployment rate hovering around 10%, the public seems outraged at the combination of three things: a) substantial TARP support to keep some firms alive, b) allowing these firms to pay back the TARP money quickly, c) no constraints on pay or other behavior once the money was repaid. Was it a mistake to allow b) and/or c)?

TARP capital purchase program investments were always intended to be limited in duration. Indeed, the step-up in the dividend rate over time and the reduction in TARP warrants following certain private equity raises were designed to encourage TARP recipients to replace TARP funds with private equity as soon as practical. As market conditions have improved, some institutions have been able to access new sources of capital sooner than was originally anticipated and have demonstrated through stress testing that they possess resources sufficient to maintain sound capital positions over future quarters. In light of their ability to raise private capital and meet other supervisory expectations, some companies have been allowed to repay or replace their TARP obligations. No targeted constraints have been placed on companies that have repaid TARP investments. However, these companies remain subject to the full range of supervisory requirements and rules. The Federal Reserve has taken steps to address compensation practices across all firms that we supervise, not just TARP recipients. Moreover, in response to the recent crisis, supervisors have undertaken a comprehensive review of prudential standards that will likely result in more stringent requirements for capital, liquidity, and risk management for all financial institutions, including those that participated in the TARP programs.

B. Mark Thoma, University of Oregon and blogger: What is the single, most important cause of the crisis and what s being done to prevent its reoccurrence? The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?

The principal cause of the financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn.

This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. Much of this occurred outside of the supervisory framework currently established. An effective agenda for containing systemic risk thus requires elimination of gaps in the regulatory structure, a focus on macroprudential risks, and adjustments by all our financial regulatory agencies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firm-wide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or system-wide, approach that should help us better anticipate and mitigate broader threats to financial stability.

Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.

Some observers have suggested that existing large firms should be split up into smaller, not-toobig- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

C. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

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Update: The last question posed by Brad de Long seems to have started an interesting debate. Paul krugman describes the position Bernanke has taken to the one Montagu Norman took during the great depression. Read more here.