In the second part of this Knowledge at Wharton interview, Patrick Harker, president of the Federal Reserve Bank of Philadelphia, discusses whether the Fed should be involved in bursting asset or credit bubbles, “too big to fail” issues, shadow banking, fintech and what surprised him during his first year in his role at the Fed. In Part 1, Harker, a former Wharton dean, talked about the limits of monetary policy, zero-bound and negative interest rates, and a coming labor squeeze from Baby Boomer retirements that is threatening a slower, “new normal” U.S. growth rate, among other topics. Harker’s made his comments during a two-day conference — “The Interplay between Financial Regulations, Resilience, and Growth” – sponsored by the Federal Reserve Bank of Philadelphia, the Wharton Financial Institutions Center, the Imperial College Business School and the Journal of Financial Services Research.

And edited transcript of the conversation follows:

Knowledge at Wharton: You will have been president [of the First Reserve Bank of Philadelphia] for a year as of July 1. What has most surprised you in your position?

Harker: Two things, I think. One, the seriousness by which people take the responsibilities across the system generally. And specifically, at the FOMC (Federal Open Market Committee). First … it’s one of the more unusual meetings in Washington. You can’t have any electronics in the room, so everybody’s actually paying attention. When was the last time you were in a meeting where nobody’s looking at a cell phone….?

People are listening. People are engaged, for two days, in a very profound way because they know the stakes. I wish we could bring other people from different parts of the government in Washington into that room, which we can’t, to just watch that process. It is really an exemplary process of people who may not always agree. We’re all looking at the same data, but we may have different perspectives. And those perspectives come from whether it’s our academic training, or our life experiences or our business experiences, whatever it is. People bring that diversity of thought to the room. But it’s done very respectfully and people want to know what the other people think. So that surprised me.

The other thing that surprised me is, when the Federal Reserve was set up — we’re a quite unique central bank relative to the rest of the central banks in the world — we were set up in a way that added that diversity across regions, because we are a big, complex country. And I think those voices coming outside are important.

But as a result, governing the system inside is complicated. What surprised me on the other side is how much time we spend just managing things like our technology investments — because it’s a collective. The 12 presidents and the 12 first vice presidents have a series of committees that actually manage the system, day-to-day. There’s no CEO of the system, and so the amount of time that we have to spend not just at the president and first vice president level, but with the head of supervision, or the — you name it, anybody here, or the head of IT. How much time we have to spend collaborating with our colleagues? And some people see that as ineffective. But actually, I don’t. I think it works. It’s not perfect, but it works.

Knowledge at Wharton: I also wanted to ask you about asset pricing, and what the Fed’s role is or should be. Should you be involved in the business of piercing an asset bubble, or a credit bubble?

Harker: That question’s come up quite a bit and I know that’s part of this conference as well. It’s a very blunt tool. We have basically one tool. And so if we see an asset bubble, say in commercial real estate, would we exercise — first, we’re assuming we can see the bubble. Right? There’s always that question that emerges: It’s easy to see a bubble in retrospect, but can you see a bubble while it’s forming…? And that question will never go away. But assume you could. Then is our one tool, the Fed funds rate, the tool we should use?

“It’s easy to see a bubble in retrospect, but can you see a bubble while it’s forming?”

I would never say never. I think in my mind, it doesn’t make sense to take a tool off the table and say you’ll never, ever use it, because you never know what you’re going to face in life. That said, there’s a pretty high bar for me to consider using that tool as opposed to other macro-prudential tools. And so as Bill Spaniel [a senior vice president and lending officer at the Philly Fed] mentioned yesterday when he opened up the conference, just looking at leveraged loans and the supervisory side of the house at the Fed, saying we have this concern and then starting to talk to the banks about the concern.

That bully pulpit, if you will, that ability to talk about these issues, also has an effect, which is not surprising. We talk about this a lot when it comes to monetary policy with forward-guidance. So the conversation about issues as opposed to actually implementing something can have an effect. But there are other tools in the world of macro-prudential regulation that can be much more effective than the blunt instrument of changing interest rates to try to pop a bubble.

Knowledge at Wharton: I want to also ask you about “too big to fail,” because it was part of the conversation in the presidential primaries. It’s this idea of breaking up the large banks — or not — or is there another way to handle this problem? In other words, is the problem size, or is the problem the level of risk, and is there some other way to approach that? What’s your view on that?

Harker: This is the conversation that we’re having right now across the country, as you said. And actually, it’s the conversation we’ve been having in this room for the last two days. So assume for a moment you say it’s size. What’s the right size? I find that hard to answer. Also, much of what happened in the crisis — we’ll use the Great Recession as an example — it wasn’t caused by the largest institutions, but by the ones that were systemically most important. And that’s a conversation we’ve also been having here at this conference.

I go back to Jeremy Stein’s 2013 speech [as governor of the Federal Reserve Bank of St. Louis], which I really think nailed it, for me. It’s a question of price versus quantity. And for us, it’s easier to think about changing prices than it is to think about changing quantity — prices in the sense of pricing the risk, endogenizing the risk — and for the risks that we can’t quite understand or endogenize, creating buffers. I think that approach — enshrined in Dodd-Frank — is in my mind at least, the more effective approach.

Is it perfect? No. And like any regulatory regime, we imposed regulations and now we’re starting to look back and say, what’s working, and what isn’t? And that’s a healthy thing to do. And so for example, you hear a lot from community banks all across the country and in this district, that … some of the burden may be a bit excessive. We need to think about that. But that said, if somebody asks me “What’s the right size?” I have a difficult time answering that, whereas I have a much easier time thinking about how to endogenize the risks and price it, and then creating a buffer.

Knowledge at Wharton: Just to be clear, in your last statement you’re talking about things like capital controls, for example?

Harker: Well, just capital buffers. And the other thing I feel strongly about is that that then puts it in the hands of management of the bank and their board of directors to decide, once the costs are fully endogenized — or close to it — what they want to do. Instead of imposing an arbitrary size limit from the outside, let those institutions decide whether, for whatever reason, they think that they have true scale economies or scope economies that allow them to do what they do — let the board and management decide that, not the regulator.

Knowledge at Wharton: I also want to ask you about the economic report out of your district here just this week [the Manufacturing Business Outlook Survey].

Harker: We have a couple of economic reports. So, manufacturing, as you can imagine, is slow. If you talk to the manufacturers in the district, they’ll say it’s not robust. In the service industries, particularly given the strength of service industries here in Philadelphia that continues to move along quite briskly. Now, we are a city of “eds” and “meds” [education and medicine] in the Philly region. So we do have very robust hiring in that sector.

But generally what we’re hearing through contacts and through things like our Manufacturing Business Outlook Survey and our Non-Manufacturing Business Outlook Survey, is what I characterized at the beginning. The economy’s moving along, but nobody’s having a party yet.

Knowledge at Wharton: So if we plotted the national trend and your district’s trends, how closely are they aligned?

Harker: Districts vary. So if you go to Texas, given the energy markets, they still are dealing with the fallout of the energy prices declining. We even see some of that in our district. So, Williamsport is the epicenter of the dry gas business, the Marcellus shale [formation] — the shale gas, as it’s called. That has really tailed off after the prices dropped. So you’re going to see a variety of reactions across the country. Again, we are a big, complex economy. And it’s hard to say there’s a one size fits all.

Knowledge at Wharton: Fed Chair Janet Yellen has said that shadow banks pose a huge challenge to the world economy. A recent estimate by the Financial Stability Board suggests that this informal lending sector is about $80 trillion now. That was as of 2014. That tripled over a 10-year period and it now accounts for about 25% of the global financial system. Tell me about your thinking of what can be done, or should be done, or how it should be monitored, and how worried or concerned you are about that.

Harker: I think we do have to be worried about that. We have to be cautious, we have to be vigilant. And if you really take this way of thinking, of system risk, broadly — which is what you’re all talking about here — then you have to take those players into account, because as you said they are large and they’re getting larger. Not only those players, but I would also argue — and we can talk about that if you want — the fintech players that are emerging in the markets as well.

“It’s a question of price versus quantity…. It’s easier to think about changing prices than it is to think about changing quantity — prices in the sense of pricing the risk.”

There’s no question that to be prudent, to do our job, we need to take all those folks into account. Now, whether we need to regulate them all or not, that’s another story, because first, there are statutory issues about what we can and cannot do. But a lot of these players are also global in nature, so we have to work with our counterparts across the world to really think about what kind of risks are they creating in the system, and what’s the appropriate way to again endogenize that risk, so the price of that risk is very clear to those who are producing it.

Knowledge at Wharton: So there are partly lending risks, but there’s also the possibility that, theoretically, you could lose control of the money supply if you have fintech lending all over the place, and blockchain, and all of these things creating new forms of money, which aren’t being printed here?

Harker: Right.

Knowledge at Wharton: Then, what do you do about that?

Harker: We’re not there right now. If you look at the fintech world, and other forms of money, there’s a lot of experimentation going on. And that’s a good thing. I think innovation comes out of that experimentation. It’s not to the point, at least in my view, where it’s creating any kind of systemic risk but it is something that we have to continue to monitor. But a lot of those companies — particularly in the fintech world — are now realizing that they may have a great idea, but they also have to create a compliance structure and culture to implement that idea in the market. And particularly in the U.S. market.

So what you’re seeing is now more partnerships between those firms and existing banks, and other financial institutions, because what the banks are good at, and what they’ve been good at for a long time, is that compliance structure — the ability to produce with economies of scale, across a variety of products. And so I think you’re going see that market shake out. There’s going be innovation.

One of the challenges we face as regulators, and that has been discussed within the regulatory framework, is how can we give the banks some space — a sandbox, if you will — so they can play with these new innovations and not with the total regulatory burden that we would typically place on them — that is, any mistake is a really bad mistake.

Knowledge at Wharton: They need some room to compete with these upstarts.

Harker: Yes, I think that’s important because the health of the U.S. economy obviously depends on the health of the financial sector. And the health of the financial sector depends on competition within the financial sector. And so it’s one of the concerns I have — that we need to make sure that the financial sector continues to be competitive. And so for the existing institutions to be effective, they need to have some room to innovate.

Knowledge at Wharton: There’s a lot of criticism of central banks in general around the world for having created too much liquidity. It’s a little bit of “damned if you do, and damned if you don’t.” Damned if you don’t save the economy, and damned if you create too much liquidity. What’s your view of that criticism? Is some of it valid? And if some of it is, where is it valid and where is it not?

Harker: It might be, but I want to go back to the conversation we had earlier. Why did we get ourselves in this situation? Because other policies have not kicked in to create higher productivity, higher real interest rates, and that I think is the fundamental issue. So I worry that we’re trying to do too much as central banks….

Take one example, one that is controversial, but it’s one that I think we have to face up to…. We’ve had this productivity slowdown worldwide now for a while. I’ll just focus on the United States. The baby boomers are retiring. Those next generations are smaller and smaller. By the way, this is what you’re seeing shaking out in higher education right now. You’re going to see more and more small to midsize colleges and universities struggling because there are fewer and fewer college-age students they’re competing over.

If you look at that, unless we get some significant increase in productivity, which I think is still plausible, we need more people. The math is real simple. If we want our GDP to grow at say … 2% to 2 ½%, unless we see that productivity growth pick up, we’re going to need more people. Where are those people going to come from? Well I think there are workers. We were talking about earlier of bringing more people who are marginally attached or unemployed for economic reasons fully into the workforce [by] getting them the skills that they need to be fully in the workforce.

“… Particularly in the fintech world, companies are now realizing that they may have a great idea, but they also have to create a compliance structure and culture to implement that idea in the market….”

One of the arguments that’s out there is if we keep interest rates low enough, everybody will get a job. Well, there is capital/labor substitution – [for example] you walk into a restaurant and you order and pay on an iPad — the wait staff no longer comes and takes your order. So you’re going to see that play out across the economy. That’s just natural. So we need to bring more people in. But we probably need to bring more people into the United States as well.

That’s a controversial issue. But I can tell you I hear from company after company: They cannot find skilled workers. That’s not just the tech companies. It’s across the board. I’ll just speak for myself one of the comparative advantages of this country is that we are very good at assimilating people who come to this country. We’re actually probably, I would argue, the best in the world at doing it. Why don’t we play to our strengths? That’s an area that I think the economy needs. And if you just step back and look over the long run, unless again, we get this productivity boost, we’re going to need more people to sustain the level of growth that we desire.