Johnson: Raise equity requirements for TBTF banks

Johnson's argument is a bit technical for us non-bankers, but the gist is this: regulators should force banks to hold more "tangible" equity -- meaning real money from investors -- as a share of their tangible assets.  A bank's tangible assets include customers' deposits (which are liabilities the bank must pay back).  

The truth is that nobody has come up with a good way to assess a bank's riskiness when they are so highly leveraged, no matter how much the banks may assure us they know how.  Right now, the banks basically regulate themselves, telling the regulators how risky they are.  This can't continue. 

Big banks resist a higher Tangible Common Equity (TCE) ratio because: 1) they can make a lot more profit using high leverage (over-borrowing) than they can raising equity from investors; and 2) if they make bad bets with borrowed money then we taxpayers will bail them out anyway.

If you're interested in this somewhat abstruse but absolutely crucial issue, you can learn more here.

A Very Strange Way to Assess the Safety of Banks

By Simon Johnson

October 1, 2012 | Bloomberg

URL: http://www.bloomberg.com/news/2012-09-30/a-very-strange-way-to-assess-the-safety-of-banks.html

Simon Johnson: U.S. has a growth crisis

Note at the end that Simon Johnson uses the "o"-word to describe today's America; and he's not some flaming liberal, he's an MIT professor and former chief economist at the IMF.

The Real U.S. Crisis Is Not the Debt Downgrade

By Simon Johnson

August 15, 2011 | Bloomberg

The U.S. has a fiscal crisis, but not the one that everyone is talking about. Standard and Poor's proved beyond a reasonable doubt that the U.S. still has the world's preeminent reserve currency. When shocks hit -- and investors have no idea who or what might be next in line for a downgrade -- they buy U.S. government securities.

Downgrades don't usually have this effect. For example, if S&P or other rating companies downgraded France, that would set off a crisis within the euro region -- pushing up interest rates on French government debt, undermining euro-area banks, and perhaps putting pressure on the fabric of the European Union itself. With a one-notch downgrade of the U.S. government, on the other hand, S&P inadvertently managed to lower the U.S.'s borrowing costs, both at the federal level and for homeowners who refinanced their mortgages.

The U.S.'s fiscal problem is not that the market questions the country's ability to pay its debts. The willingness to pay was clearly proved by the outcome of the debt-ceiling debate, when even a majority of Tea Party adherents in the U.S. House of Representatives voted to lift the ceiling (though it would have passed without their votes). We most definitely do not have the kind of solvency crisis experienced by some emerging markets and now, for the first time, parts of Western Europe.

Growth Crisis

Instead, our crisis has two dimensions. First, we have a growth crisis. My MIT colleague, Daron Acemoglu, in a blog post on the Harvard Business Review website, makes the point vividly. In his view, one percentage point extra growth per year for the next 20 years would fix the U.S.'s budget problems. If we could manage to increase our growth rate from 2 percent a year to, say, 3 percent over the long haul, that would greatly boost average incomes, as well as tax revenue.

Acemoglu also argues that the U.S. economy can grow through innovation, but only if U.S. policies foster more basic scientific research and more effective commercialization of technology. The U.S. also needs to improve its patent system and allow more skilled foreign workers into the country, Acemoglu says.

The general policy mood may be shifting in this direction. Jeb Bush, the former Florida governor, and Kevin Warsh, a former Federal Reserve governor, made similar points in a Wall Street Journal op-ed last week. Bush's rhetoric was suitably vague for someone who is likely to run for president in 2016. Bush and Warsh felt the need to repeat the mantra of the day, "Cutting spending is essential," and then quickly made the right point: "But we will never cut our way to prosperity."

Income Distribution

Restoring growth is not easy because of a second, more debilitating element -- a paralyzing fight over the distribution of income, in which powerful people can block the government from doing anything sensible if that is against their narrow interest.

This dynamic can be seen in the debate over who will foot the bill for the 2008 financial crisis, which caused a deep recession that pushed up the federal government's medium-term debt -- what we should expect by 2018 for example -- by about 50 percent of gross domestic product. (You can check the Congressional Budget Office numbers yourself; start with points 9 and 10 in my testimony to a July 13 joint hearing of the Senate Finance and House Ways and Means committees. The testimony was not refuted.)

Someone Pays

To control future debt levels, someone has to pay for that fiasco. But people in high-income brackets, working with various allies, have dug a brilliant defense against tax increases in the form of the Tea Party. Backed by 30 percent of the population, this group exploits the broad design of the U.S. Constitution, which gives well-organized minorities an effective veto power over major policy changes. The result is that, instead of letting President George W. Bush's tax cuts for the rich expire, we are headed for deep spending cuts that disproportionately affect the less-well-off.

More generally, powerful lobbies have amassed great privilege in the political system, and they can't be easily moved from their positions. For example, Jeb Bush and Warsh say, quite reasonably, "If banks are 'too big to fail,' they are too big. They must be allowed to succeed or fail on their own merit, without any hint of government support." But there is precisely no chance that Congress, the Federal Reserve or the executive branch will end the subsidies that undergird big banks, and that keep them in business through essentially free insurance against downside risk. Watch Bank of America in the weeks ahead for the next demonstration of what it means to be too big to fail.

Innovation and Growth

Acemoglu and James Robinson of Harvard University have a forthcoming book, "Why Nations Fail: The Origins of Power, Prosperity, and Poverty," that attributes economic success to political institutions that support innovation and growth. (Disclosure: I had nothing to do with writing the book, but they draw on research the three of us did jointly.)

The U.S. has done well over 200-plus years in most of the areas Acemoglu and Robinson stress. But the country now seems to be in the grip of an oligarchy that is determined to protect its position at the expense of spending for the public good on things like education and scientific research. Nations frequently fail when powerful interest groups block change. If this is the U.S. situation, it's more serious than any rating company's view on debt levels.

Simon Johnson: What caused nat'l. debt, how it concerns banks

Like it or not, the CBO is the budget deficit scorekeeper cited by Republicans and Democrats alike. For all you who think Obama blew up the deficit and our national debt with his reckless spending, read and understand this: as for the difference (increase) between the CBO's 2008 national debt estimate for 2018 and its 2010 debt estimate for 2018, 57 percent was due to decreased tax revenue resulting from the financial crisis and recession, 14 percent was for entitlements (including increased unemployment insurance and early retirement/Social Security), and only 17 percent was due to increases in discretionary spending, including the stimulus bill.

In other words, the Bush's Great Recession pulled the chair out from under our economy, and therefore our tax revenue base. At the same time, it increased people's need for entitlement spending when they lost their incomes. That is why our debt is projected to skyrocket, because revenues have crashed, but spending has only increased.

The main part of Johnson's article, however, is about the need to increase regulation on financial firms, namely to increase their capital requirements as a buffer against risk-taking which hurts all of us, both through bailouts and lost tax revenue, when those risks result in a financial crisis. Republicans in Congress oppose higher capital requirements for one reason only: Wall Street pays them to oppose it. They've learnt nothing from the past 3 years.

Low Bank Capital Is Next Fiscal Crisis: Simon Johnson

By Simon Johnson

August 1, 2011 | Bloomberg

The summer debate that has dominated Washington seems straightforward. Under what conditions should the U.S. government be allowed to borrow more money? The numbers that have been bandied about focus on reducing the cumulative deficit projection over the next 10 years, as measured by the Congressional Budget Office.

But there is a serious drawback to this measure because it ignores what will probably prove to be the U.S.'s single largest fiscal problem over the next decade: The lack of adequate capital buffers at banks.

The Congressional Budget Office was created in 1974 to provide nonpartisan analysis of budget issues. This was a major breakthrough. It's hard to exaggerate the lack of serious and timely budget information that existed previously. The CBO still does great work, but it has a major blind spot. (Disclosure: I'm a member of the CBO's panel of economic advisers; I don't speak for them here or anywhere else.)

The CBO is very good at explaining how the U.S. got itself into a fiscal mess. The primary cause of the government debt surge in recent years was a huge recession. A big loss of gross domestic product and a fall in employment in any country will collapse tax revenue. To appreciate the magnitude of this disaster in the U.S., compare the CBO's baseline forecasts immediately before and after the financial crisis.

Debt Projections

In January 2008, before anyone thought the crisis would spin out of control, the CBO projected that total government debt in private hands -- the best measure of what the government really owes -- would reach only $5.1 trillion by 2018, which was then the end of its short-term forecast horizon. That represented a fall in real terms to just 23 percent of GDP. Some House Republicans might argue that even this level of debt relative to the size of the economy is too large, but there is no evidence that such debt levels by themselves stall growth or cause other ill effects. The U.S. carried government debt at or slightly above this level throughout the 1950s and the decades that followed.

As of January 2010, once the depth of the recession became clear, the CBO projected that over the next eight years debt would rise to $13.7 trillion, or more than 65 percent of GDP -- a difference of $8.6 trillion. In January 2011, CBO moved the forecast for 2018 to $15.8 trillion, or 75 percent of GDP, primarily because the damage to growth had proved even more prolonged than anticipated.

Fiscal Impact

Most of this fiscal impact is not due to the Troubled Asset Relief Program -- and definitely not to the part of TARP that injected capital into failing banks, most of which has been repaid. Of the change in the CBO baseline (comparing 2008 and 2010 versions), 57 percent is due to decreased tax revenue resulting from the financial crisis and recession, and 17 percent is due to increases in discretionary spending, including the stimulus package made necessary by the financial crisis (and because the "automatic stabilizers" in the U.S. are relatively weak). An additional 14 percent came from increased interest payments on the debt, and the rest from increases in mandatory spending, otherwise known as entitlements. Some of the entitlement spending, which includes food stamps, unemployment, and other support payments, is also due to the recession.

Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue.

Important Paper

The single most important paper to read on future fiscal crises is actually about bank capital -- why the U.S. and other countries need to increase it and why arguments to the contrary are wrong. The paper was written last year and revised in March by Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer, and is called "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive." The work by Admati and her colleagues is not partisan. In fact, her work has drawn support from finance experts across the political spectrum, including John Cochrane, a professor of macroeconomics and finance at the University of Chicago, who recently wrote an op-ed supporting the Admati approach.

Larger Buffers

Low levels of bank capital are just one way to measure the extent to which banks endanger the broader economy by financing themselves with debt rather than equity. Higher capital in any system means more equity and larger buffers against losses. In a brilliant speech recently, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, connected the dots by showing the extent to which the U.S. Tax Code encourages dangerously excessive use of debt by households, companies and banks.

Kocherlakota argues persuasively that U.S. policy should aim to reduce the use of leverage -- and that there are much safer ways if the U.S. wants to subsidize first-time homebuyers or business investment. Tax reform that encourages financial firms to use equity instead of debt should be scored as lowering likely future government deficits.

Fiscal Risk

Many House Republicans -- including some who say they are fiscal conservatives -- as well as some House Democrats remain strongly in favor of lowering capital requirements.

But any true fiscal conservative should fight to strengthen the legislative and regulatory safeguards that aim to make the financial system less prone to collapse. Pushing for lower capital requirements in the financial system poses a major fiscal risk. It is unfortunate that fiscal risks arising from the financial sector are not currently scored as claims on the federal budget by the CBO. This introduces a false separation between financial and fiscal issues on Capitol Hill.

The CBO is only as good as Congress allows it to be. The CBO itself should push hard in this direction. The agency is good about scoring other contingent liabilities and implicit guarantees. Future health-care costs, for example, are assessed on the basis of probabilities. No one knows what the world will look like in 2050, but the CBO should be able to warn taxpayers and lawmakers what will probably happen in the future, based on the immediate past.

Simon Johnson: Big battle over 'small' debit card fees

The convenience of using your debit card is not free. The average transaction fee to the merchant from your bank is 44 cents. The Fed estimates that in 2009 these fees totaled $15.7 billion. Of course, this cost gets passed on to us consumers.

Meanwhile, banks' average cost of servicing debit card transactions with merchants is 4 cents. So, on average they make 40 cents or 1,000% gross profit on each transaction!

Democrat Sen. Dick Durbin has proposed that the Fed require banks to lower debit-card fees to a level closer to the actual cost of transactions. The so-called Durbin amendment gives a specific exclusion for small or community banks with under $10 billion in assets, so that the Fed's new price-setting power won't inadvertently favor big banks with economies of scale which can more easily lower their fees than small and community banks.

But of course others in Congress are trying to protect the TBTF banks' fee scam. They say they are trying to protect consumers and smaller banks.

Who will win?

Since nobody is paying attention or seems to care, I put my 44 cents on the big banks.

The takeaways for smart consumers seems to be: use a small local bank; and use cash. Help yourself and others out by leaving your credit and debit cards at home.

Small Banks and Debit-Card Reform

By Simon Johnson

May 12, 2011 | New York Times

URL: http://economix.blogs.nytimes.com/2011/05/12/small-banks-and-debit-card-reform/

Simon Johnson: TARP report on 'Citi weekend,' moral hazard of TBTF

As Johnson describes, countries which host TBTF banks become their hostages when those banks act irresponsibly and cause a crisis. This is TBTF's moral hazard:

"This [TBTF banks' global presence] is also a major problem for the 'just let 'em go bankrupt' philosophy. There is no framework for cross-border bankruptcy, in the sense of clear rules about who gets compensated with what kind of assets. The courts can presumably sort it out, but it would take many years and cost billions of dollars in legal and other fees. As a result, if a large bank is on the brink of failing, everyone will assume the worst around the world and run for the doors."

[...]

"Or we could also make the biggest banks smaller -- ideally, small enough to fail. This was the proposal of the Brown-Kaufman amendment to Dodd-Frank, which died on the Senate floor, largely because of opposition from Geithner and the Treasury Department. So we'll do nothing, it seems, except let these massive banks become bigger and even less well managed.

"Until next time, the people who run the country will again face the same choice as in November 2008: provide an unsavory bailout for management, shareholders and creditors that rewards failure and stupidity, or run the risk of causing a second Great Depression.

"If the big banks get large enough, we'll become like Ireland today -- saving those institutions will ruin us fiscally, destroy the dollar as a haven currency, and end financial life as we know it."

'Citi Weekend' Shows Too-Big-to-Fail Endures: Simon Johnson

By Simon Johnson
January 18, 2011 | Bloomberg

URL: http://www.bloomberg.com/news/2011-01-18/-citi-weekend-shows-too-big-to-fail-endures-commentary-by-simon-johnson.html

Simon Johnson: Goldman creating new bubble with taxpayer cash

"Goldman is not a venture capital fund or primarily an equity-financed investment fund. It is a highly leveraged bank, meaning that it borrows through the capital markets most of the money that it puts to work." And where does Goldman borrow that money? From you and me -- the Fed Reserve.

Some people say Goldman is the smartest. I say they're the most brazen. They pay off whom they can, and bully the rest.

Why Are Taxpayers Subsidizing Facebook, and the Next Bubble?

By Simon Johnson
January 6, 2011 | New York Times

Goldman Sachs is investing $450 million of its own money in Facebook, at a valuation that implies the social-networking company is now worth $50 billion. Goldman is also creating a fund that will offer its high-net-worth clients an opportunity to invest in Facebook.

On the face of it, this might seem just like what the financial sector is supposed to be doing – channeling money into productive enterprise. The Securities and Exchange Commission is reportedly looking at the way private investors will be involved, but there are more deeply unsettling factors at work here.

Remember that Goldman Sachs is now a bank-holding company – a status it received in September 2008, at the height of the financial crisis, in order to avoid collapse (see Andrew Ross Sorkin's blow-by-blow account in "Too Big to Fail" for the details.)

This means that it has essentially unfettered access to the Federal Reserve's discount window – that is, it can borrow against all kinds of assets in its portfolio, effectively ensuring it has government-provided liquidity at any time.

Any financial institution with such access to such government support is likely to take on excessive risk – this is the heart of what is commonly referred to as the problem of "moral hazard." If you are fully insured against adverse events, you will be less careful.

Goldman Sachs is undoubtedly too big to fail – in the sense that if it were on the brink of failure now or in the near future, it would receive extraordinary government support and its creditors (at the very least) would be fully protected.

In all likelihood, under the current administration and its foreseeable successors, shareholders, executives, and traders would also receive generous help at the moment of duress. No one wants to experience another "Lehman moment."

This means that Goldman Sachs's cost of financing is cheaper than it would be otherwise – because creditors feel that they have substantial "downside protection" from the government.

How much cheaper is a matter of some debate, but estimates by my colleague James Kwak (in a paper presented at a Fordham Law School conference last February) put this at around 50 basis points (0.5 percentage points), for banks with more than $100 billion in total assets.

In private, I have suggested to leading members of the Obama administration and Congress that the "too big to fail" subsidy be studied and measured more officially and in a transparent manner that is open to public scrutiny – for example, as a key parameter to be monitored by the newly established Financial Stability Oversight Council.

Unfortunately, so far no one has taken up this approach.

However, there is consensus that the implicit government backing afforded to Fannie Mae and Freddie Mac in recent decades allowed them to borrow at least 25 basis points (0.25 percent) below what they would otherwise have had to pay – a significant difference in modern financial markets.

In "13 Bankers," Mr. Kwak and I refuted the view that these government sponsored enterprises were the primary drivers of subprime lending and the 2007-8 financial crisis – that debacle was much more about extreme deregulation and private-sector financial institutions seeking to take on crazy risks.

Nonetheless, Fannie and Freddie were badly mismanaged – and followed the market in 2005-7 with bad bets based on excessive leverage – in large part because they had an implicit government subsidy. Those institutions should be euthanized as soon as possible.

Goldman Sachs now enjoys exactly the same kind of unfair, nontransparent and dangerous subsidy: it has effectively become a new form of government-sponsored enterprise. Goldman is not a venture capital fund or primarily an equity-financed investment fund. It is a highly leveraged bank, meaning that it borrows through the capital markets most of the money that it puts to work.

As Anat Admati of Stanford University and her colleagues tirelessly point out, the central vulnerability in our modern financial system is excessive reliance on borrowed money, particularly by the biggest players.

Goldman Sachs is a perfect example. Most of its operations could be funded with equity – after all, it is not in the retail deposit business. But issuing debt is attractive to shareholders because of the subsidies associated with debt financing for banks and to bank executives because their compensation is based on return on equity — as measured, that increases with leverage.

If banks have more debt relative to equity, this increases the potential upside for investors. It also increases the probability that the firm could fail — unless you believe, as the market does, that Goldman is too big to fail.

Social-networking companies should be able to attract risk capital and compete intensely. They do not need subsidies in the form of cheaper financing, or in any other form.

Social networking is a bubble in the sense that e-mail was a bubble. The technology will without doubt change forever how we communicate with each other, and this may have profound effects on the nature of our society. But investors will get carried away, valuations will become too high and some people will lose a lot of money.

If those losses are entirely equity-financed, there may be negative effects, but they are likely be small – in the revised data after the 2001 dot-com crash, there isn't even a recession (there were not two consecutive negative quarters for gross domestic product).

But if the losses follow the broader Goldman Sachs structure and are largely debt-financed, then the American taxpayer will have helped create another major financial crisis.

And if you think that sophisticated investors at the heart of our financial system can't get carried away and lose money on Internet-related investments, remember Webvan: "During the dot-com bubble, Goldman invested about $100 million in Webvan, the online grocer that never got off the ground and eventually collapsed in bankruptcy."

Johnson: No fiscal conservatives

In the U.S., No True Fiscal Conservatives

By Simon Johnson

October 14, 2010 | New York Times

Simon Johnson, the former chief economist at the International Monetary Fund, is a co-author of "13 Bankers."

In most industrialized countries, attention is now shifting to some form of fiscal austerity — meaning the need to bring budget deficits under control.

In Britain, for example, an active debate is under way between those on the right of the political spectrum (who want more cuts sooner) and those to the left (who would rather delay cuts as much as possible). There is a similar discussion across the European continent, with the precise terms of the debate depending on which party was most profligate during the long boom of the 2000s.

The United States stands out as quite different. No one is yet seriously proposing to address our underlying budget problems. Certainly, some people consider themselves fiscal conservatives — some of the right and some of the left — but none can yet be taken seriously. The implications for our fiscal future are dire.

The background, of course, is that the United States budget was in relatively good shape at the end of the Clinton years (culminating in a surplus of 2.5 percent of gross domestic product in 2000), but it turned sharply into deficit during the George W. Bush era. The 2 percent deficit in 2006 perhaps did not look too bad, for example, but it was a remarkably poor performance given how well the economy was doing.

The notion that tax cuts would lead to productivity increases, bolstering growth and in turn fixing the budget, turned out to be completely illusory. In fact, the tax cuts encouraged consumption, leading to overspending at the national level (and reflected in a current account deficit that reached 6 percent of G.D.P., with a large increase in borrowing from foreigners by both the private sector and the government).

But what really busted the United States budget and pushed up our debt-to-G.D.P. ratio was the way the financial system amplified the housing-based boom-and-bust through 2008. While there were some "feel good" effects through the end of 2007, we then faced the worst recession since World War II.

Net government debt held by the private sector will increase to around 80 percent of G.D.P., from about 42 percent, as a direct result of the economic crisis — and the measures taken to prevent it from turning into another Great Depression.

The Congressional Budget Office agrees that the increase in debt-to-G.D.P. from the crisis is about 40 percentage points. Treasury Secretary Timothy F. Geithner has offered a very different view — and an overly narrow one — framed in terms of an assessment of only the Troubled Asset Relief Program: "The direct costs of the government's overall rescue strategy are likely to be less than 1 percent of G.D.P."

The increase in our budget deficit to 10 percent in 2009 and 2010 was primarily because of our automatic stabilizers; the government took in less revenue as tax receipts fell and paid people more in unemployment benefits. Only 17 percent of the increase in government debt (in the baseline budget of the Congressional Budget Office) is because of discretionary spending of any kind.

Think what you like of the fiscal stimulus — either the Bush 2008 version or the Obama 2009 effort: it is simply not the big-ticket item its critics make it out to be.

If you want to fix the United States budget, keeping the deficit under control and reducing government's debt, you must address the risk-seeking behavior of big banks. No fiscal strategy can be credible without addressing the major problem that brought us to this point.

Of course, you can make proposals that seek to cut spending and raise revenue — see, for example, the recent effort by Bill Galston and Maya MacGuineas from the Committee for a Responsible Federal Budget. Some of their ideas are worth discussing — and they are right to put everything on the table (although, personally, I would err on the side of more comprehensive tax reform).

But the simple fact of the matter is that our fiscal position has been ruined by the behavior of big banks — and these banks are now free to make the same or larger mistakes as we head into the next credit cycle.

The unfortunate fact is that those who style themselves as fiscal conservatives largely stayed on the sidelines during the financial regulation debate. And the problem of too-big-to-fail was absolutely not addressed adequately either by the Dodd-Frank legislation or the subsequent Basel III framework (as The Financial Times reported this week).

There is no way to handle the failure of a global megabank, and the management of such banks know this and so do their creditors (as Gillian Tett noted in a trenchant Financial Times column). This amounts to carte blanche for further uncontrolled expansion of risk-taking.

In some sense, this is all water under the bridge — like it or not, the overhaul process for systemic risk is done, and achieved little. But in that case, any true fiscal conservative should recognize the risks posed by megabanks going forward and adjust their budget targets accordingly.

In particular, the commonly discussed target for our government debt-to-G.D.P. ratio of 60 percent seems unreasonably high, given the risks posed by our financial system. We should probably aim instead for a target of 20 percent or lower, as do the most responsible emerging markets in Asia or the Baltics.

Fiscal conservatives — and everyone else — will most likely ignore this advice. In that case, we'll soon face a major fiscal crisis in the United States, again as a direct result of financial sector irresponsibility. Then taxes will rise as Social Security benefits fall sharply, and unemployment increases beyond current levels.

We're subsidizing banks' political speech

So the finance sector donated $463 million to Congress in 2009, the most ever. Think about how outrageous that is: Congress voted for a huge Wall Street bailout, which the finance sector turned around and donated back to Congress. Moreover, now that corporations are "people," we're all subsidizing big banks' "right" to free "political" speech. We're so f-ed.


Too Big for Us to Fail
We need counterweights not just to Wall Street's toxic products but to its malign influence.

By Simon Johnson and James Kwak
April 26, 2010 | Prospect.org

URL: http://prospect.org/cs/articles?article=too_big_for_us_to_fail

Simon Johnson & James Kwak on breaking up the U.S. oligarchy

I'm including only this semi-optimistic excerpted quote from 13 Bankers co-author, BaselineScenario.com co-creator, and MIT business professor Simon Johnson, in order to give some much needed historical perspective on the crisis we find ourselves in today.

Bill Moyers Journal

Interview with Simon Johnson and James Kwak

April 23, 2010 | PBS

[...]

Bill Moyers: But we can't compete with those lobbying dollars. We can't compete with this interlocking oligarchy that you say. That's a fact.

Simon Johnson: Bill, in 1902, when Theodore Roosevelt took on the industrial trusts, nobody knew what he was doing. Nobody thought he could win. The Senate was called the Millionaires Club for a reason. And it wasn't even any theory. The antitrust theory, everything we know and believe about monopoly, why monopoly is bad for society, didn't really exist, certainly not in the mainstream consensus, when Roosevelt decided to take on J.P. Morgan, okay?

Ten years later, the mainstream consensus has shifted completely. People understood from the debate and from the struggle, from the fact- from the way the trusts fought back and the way they spent their money, they began to understand this was profoundly dangerous, politically and socially. 1912, everyone agreed that breaking up Standard Oil was a good idea. Had to be done. They broke into 35 companies, most of them did well. The shareholders actually made money. It's a very American resolution, Bill. And it's very clear that we've had this confrontation before in American history: Andrew Jackson against the Second Bank of the United States in the 1830s, Jackson won, barely; Theodore Roosevelt, the beginning of the 20th Century; FDR in the 1930s.

The American democracy was not given to us on a platter. It is not ours for all time, irrespective of our efforts. Either people organize and they find political leadership to take this on, or we are going to be in big trouble, okay?

MIT economist Simon Johnson on breaking up TBTF banks

Simon Johnson: Wall Street's Stranglehold on Our Democracy Must Be Broken

The progressive economist talks about the fight to reform Wall Street, what Robert Rubin should do with his money, and why Jamie Dimon is the most dangerous man in America.

Interview with Simon Johnson by Zach Carter

April 17, 2010 | AlterNet

Simon Johnson is the former chief economist for the International Monetary Fund, and co-founder of the Baseline Scenario, a blog about the financial crisis and financial reform. He is a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. Johnson's latest book, 13 Bankers (co-authored with Baseline Scenario co-founder James Kwak) is a detailed examination of Wall Street's political and ideological power and the devastating economic results. AlterNet's economics editor Zach Carter recently talked with Johnson about the U.S. banking system.

Zach Carter: Your push to break up the largest banks into smaller banks that can actually fail without wreaking havoc on the economy has been very well-received by progressives. But historically, the IMF and the Federal Reserve are not exactly hotbeds of progressive thought. How did you and Paul Volcker become the vanguard of the economic left?

Simon Johnson: The ideas that we're advancing both in Baseline Scenario and in the book should appeal to people on the right, the center and the left. There's an article by Arnold Kling that we wrote about on Baseline Scenario. He's a libertarian, which I am not, but he's come around to our way of thinking about the banks. If you think about it from the right, our financial system is just monstrously unfair. It's not in any way a market economy to have these banks who are so big that the government can't let them fail. They have funding advantages over other banks, and those advantages only encourage them to get bigger. That's just not reasonable.

The left—which coincides more with my own views than the right—is very uncomfortable with the power structure that is inherent in that imbalance. And the center--which I would also say characterizes my own views, I'm a center-left person—the center is very concerned about the effects of giant banks on efficiency and the interworkings of the economy. You can see the spectrum of appeal from the blurbs on our book.

ZC: Sen. Jim Bunning, R-Kentucky, is a fan.

SJ: I thought we just had to include Jim Bunning, because what else would these people agree on? You can't list five other words in the entire English language that Bunning and Alan Grayson would agree on outside of financial reform.

ZC: But doesn't the broad appeal of your argument run counter to the basic idea? Your point is that Wall Street has taken over the economic ideology in Washington, D.C., but just by looking at the cover, we can see several economists and politicians who agree with you that what is good for Wall Street is often bad for society.

SJ: The ideological capture was complete through 2005 and 2008. I think now there's been some push-back against it. I think this is an ideological debate. I think it's a debate about doctrines and the real nature of a market economy. So there are now people who are pushing back. But I can assure you, Wall Street still has a fantastic grip at the top levels of this administration and on Capitol Hill.

We are in the fight, at least, and we have some people on our side, but it is very, very lopsided. Did you see Chris Dodd told Don Imus that he's reading 13 Bankers? I was quite amazed by that. So we're at the table, but it's going to be an uphill battle for some time.

ZC: You've been making this argument for more than a year now, that there's no way to fix our financial system without breaking up the big banks. But watching the debate over financial reform, Congress really hasn't seriously considered the idea. Is this something we can hope to enact with this reform bill, or are you geared up for a longer fight?

SJ: It's a longer fight. There is a slim chance—maybe it's five percent, maybe it's ten percent—that in this legislative cycle, the White House will change its position. And I think after they got a pretty good final outcome on health care, all things considered, a re-energized President Obama saying, "Anybody who opposes us is on the side of the too-big-to-fail banks, and here's how we're going to make them smaller" would have a tremendous effect. That's a very powerful message, and that's what we're telling the White House.

The political side of the White House, I think, finds that very appealing. The economic side of the White House, of course, is in a very different place, which is why the odds are about 90 percent against us. But that's just in this legislative cycle, and this is not a one-cycle debate. It took 10 years for Theodore Roosevelt and the people who came after him to change the consensus around big business in the U.S. at the beginning of the 20th century. [i.e. the Progressive Era movement - J] I think we're in a five- to ten-year fight to change and reshape the consensus. And I think the response to the book is very encouraging.

Not that Chris Dodd will suddenly change his mind and we'll see a sudden legislative shift, but that we'll have a good chance of moving the entire mainstream thinking on this—including mainstream left and mainstream right—away from support for this oligopoly. People currently think, 'Oh my gosh, we cannot allow a monopoly on an industrial product." After a hundred years, that's a mainstream view. But what people don't get is that massive banks are incredibly dangerous, too.

I would point to J.P. Morgan Chase CEO Jamie Dimon's letter to his shareholders this week as an indication of what we're up against. He says they should be allowed to get as big as they want, and that's how the free market works. Well no, Jamie, that's not a free market. That is the result of unfair competition and an implicit government subsidy.

ZC: He also completely ignores all of the egregious things his bank did over the past decade, particularly the $30 billion subprime operation. But it does seem like there has already been some positive ideological movement. When you were pushing this idea a year ago, a lot of people viewed it as crazy. That doesn't seem to be true any more. Lots of people still disagree with you, but your views have become an acceptable part of the dialogue.

SJ: I think that's true. But you also saw the Volcker rule in January, which turns out, I admit, to be rather tepid. Nevertheless, seeing the president say, "If these guys want to have a fight, let's have a fight," was very important. And to see Treasury willing to take on the financial lobby, even the Chamber of Commerce, is noteworthy, although it's only been over consumer protection. Treasury official Neal Wolin gave a pretty good speech recently where he said, "Look, you're spending $1.5 million a day on lobbying and employing four or five lobbyists per member of Congress. This is totally unacceptable, and you're not even representing the interests of all your members."

ZC: And Wolin is a former lobbyist for the financial industry.

SJ: Yes! If you gave me the opportunity, I would hire some of those people, too. In the U.K. there is an expression, I don't know if it works in the U.S., but it's "Hire poachers and turn them into gamekeepers."

ZC: The first SEC Chairman was Joe Kennedy, and he wasn't exactly a shining example of business integrity.

SJ: It takes one to know one, right?

ZC: Let's talk about the revolving door, though. A lot of people from Wall Street leave to work in Washington, and then go right back. The top bank regulator in the country used to be one of the top bank lobbyists, and he hasn't done a very good job as a regulator. How do you exploit the expertise of the financial sector without succumbing to its excesses?

SJ: Well yes, the revolving door is obviously out of control, and I didn't mean to say you should exclusively employ poachers, that doesn't go well. What you need is a very strong set of incentives and guidelines, and you need people at the top of the regulatory chain who truly believe that the bad aspects of the financial sector need to be curtailed. We haven't had that for a very long time. You saw just last week, a guy left Barney Frank's staff to become a financial lobbyist. Not to pick on that one guy, but it's a perfect illustration of how the whole culture between Wall Street and Washington is just totally out of whack.

You probably need to come in with some overly draconian initial restrictions, like banning anyone from revolving through the door for a period of five years. Once the cultural perceptions about Wall Street change, you can maybe relax those rules a bit. But right now it's just so massively out of control, it really does need strong action.

ZC: I want to ask you some smaller-bore economic questions. At a certain point, there was a lot of public debate on executive compensation, which has subsequently disappeared from the reform push. What role did executive compensation play in the crisis, and do people have a right to be angry about it?

SJ: Yes, people have a right to be angry about it. I think it's a symptom of a deeper problem. I don't think you can just fix executive pay by itself, because people will find other ways to compensate themselves that get those restrictions. But a lot of pay that rewards short-term performance is undoubtedly a reflection of the dangerous incentives in our financial system.

There was a very nice write-up in the Washington Post going through how people are being paid, and the executives of big banks, most notably John Stumpf, head of Wells Fargo, are getting just huge cash payouts. And those payouts are absolutely not in line with what the administration asked them to do.

I think this shows two important things. First, when you ask bankers nicely to do something, they just don't do it. Second, when Wells Fargo was pressed on why Stumpf was getting paid so much, his spokesperson said, "Well, we had a really good year in 2009." I'd say that, actually, no, you didn't have a good year, you were saved like all of the other big banks by the government. That is not a good year from a social point of view, it's not a good year if you're trying to run a bank well, and paying this much cash is completely inappropriate. It reflects how deep we are in this mess. We haven't gotten out of it.

ZC: So would you say that too-big-to-fail and excessive Wall Street pay are connected?

SJ: Yes, I would say they are two sides of the same coin. But I would caution that if you fix too-big-to-fail, I wouldn't have a problem with the compensation. Then I think it's an issue for shareholders and corporate governance that the company's owners can either take on or ignore.

If some hedge fund, for example, makes a lot of money and pays its guys a lot of money, I don't really have a problem with that, so long as they aren't creating systemic risk. I'm an entrepreneurship professor at M.I.T, I like people who take risks. What I don't like is people who play with house money, which in this case is the taxpayers' money.

ZC: Your background is with the IMF. Drawing on that experience—do financial crises of the size and scope of what we've just experienced take place without widespread fraud?

SJ: It's a good question. You never know how much fraud there is unless big banks actually collapse. You can see this around Lehman. We knew Lehman was a sharp operator, we knew Lehman was really skating along the edge in many ways, but we didn't know they were engaged in outright fraud. And in fact, even after the revelations about their Repo 105 plan to hide assets from investors, we still don't know if that behavior can be proved fraudulent in a court of law.

They certainly bent the rules massively. They certainly misrepresented things to their investors and to the market. Whether they can be held accountable for that is another question, unfortunately.

But you never really find out about fraud until the company collapses, because after that, nobody wants to do business with them anymore, and nobody wants to cover for them. Nobody thinks, "If I get tough on Lehman, they won't give me any more good trades," because Lehman is gone.

This is what protects the big guys right now, the J.P. Morgans, even Citigroup, which most people on Wall Street really dislike and regard as very poorly run. Even Citi is immune from some level of criticism because there are hedge fund people and people on Wall Street who are very knowledgeable and want to do business with those companies going forward. As long as a company stays in business, the public will never know what was fraudulent and what was not.

ZC: So what's the difference between an Enron-style scandal where people go to jail and what we just lived through?

SJ: I think there are a lot of parallels. With Enron, we never found out about anything until the firm collapsed. After that, there were prosecutions. So we should wait and see how things play out. But the rules that apply to the financial sector are very loosey-goosey, and much more open to interpretation and exploitation than the rules that apply to other companies. Enron was sort of a weird hybrid that committed many financial infractions, but they weren't a bank, and they didn't have the kind of protection that you get from being a bank and being regarded as central to the credit system.

ZC: But they were involved in the derivatives market, and they did engage in accounting hijinks.

SJ: Right, although by today's standards, of course, they were small-scale and primitive.

ZC: But shouldn't that scandal have sounded an alarm somewhere? Shouldn't there have been some broader federal response after Enron?

SJ: Well, the big alarm bell was the failure of the Long-Term Capital Management hedge fund in 1998. And the extraordinary thing, which we point out in 13 Bankers, is that Brooksley Born actually rang the alarm bell before the Long-Term Capital Management crisis, and she was ignored, marginalized and attacked for it.

I think Enron was actually misconstrued, because people dismissed it, saying it was just fraud, they just failed to disclose important things to shareholders. And we did get the Sarbanes-Oxley Act out of it, and I don't think that was a bad idea. But the response did not cut to what now appears to be the heart of the problem.

ZC: You've done a very good job emphasizing the conflict between big banks and the broader economy. But there are also conflicts between the managers of companies and the shareholders who own them. How do you align those incentives to prevent executives from looting their own firms, as thousands did during the savings and loan crisis?

SJ: That's a very tough problem and it gets to the heart of our modern economy. The central problems in the economy today are these agency problems, the phenomenon in which the people who run companies are controlled only very indirectly by shareholders or anyone else. And in big, complex enterprises, its easy to hide a lot of stuff. Remember even small banks are relatively large and complex compared to other businesses.

The savings and loan crisis was very much about regulatory failure, and about regulators being encouraged to look the other way by the executive branch and by Congress. At the end of the day, though, I would emphasize that the savings and loan crisis resulted in more than 750 people going to jail and more than 2,000 institutions going out of business—all without bringing down the global economy.

You cannot expect for there to be zero fraud in a country like the United States, with its dynamic culture and its complexity. It's just part of the way we are. What you want to make sure is that the economic structures you create cannot be completely destroyed by the actions of one, two, or thirteen bankers who engage in things you and I would consider fraudulent. That's obviously not where we are today.

ZC: In a recent column in the New York Times Paul Krugman argued that breaking up the big banks won't solve all of our problems, that the bank crash of the 1930s was mostly small banks, and the government made a mistake when it allowed them all to fail. Do you have a response to that?

SJ: The 1930s obviously taught us a very important lesson, particularly the need for deposit insurance. I would not want us to have small banks fail in the context where you had removed federal deposit insurance, but that's not going to happen. That's never going to happen. That aspect of a retail panic run is something people have to take away from the '30s experience.

Now, when you've prevented that, you've introduced a distortion into the system, because people now have protected sources of money, so they won't pay much attention to how the institution is governed. That means you have to have substantive regulations.

I'm not suggesting that we forbid or outlaw crises. That's impossible. But ask yourself this question. If Citigroup had failed in 2008—this is a little funny because of course they did fail, and we saved them—but in 2008, they had a total balance sheet of about $2.5 trillion. That's 17 percent or 18 percent of the U.S. economy. If they had been a $5 trillion bank, or a $10 trillion bank. If they'd been on a scale relative to the U.S. economy of what we saw in Ireland or the U.K.—in the U.K., Royal Bank of Scotland peaked at 1.75 times the U.K. economy, by our calculations. So let's say Citigroup was a $20 trillion bank. Would our problems today be better or worse?

That's question number one. Question number two is, are the incentives for the banks now to become bigger or smaller? Jamie Dimon's letter to his shareholders is very clear on this. He thinks if you do well, you should be allowed to get as big as you want. That is incredibly dangerous.

Actually, Jamie Dimon may be the most dangerous person in America today. He's dangerous because he's good. I fear the collapse of Citigroup, and I find Goldman Sachs more entertaining than anything else. They really help us because they aggravate so many people. But Jamie Dimon is smart. Jamie Dimon keeps his head down, and Jamie Dimon keeps getting bigger. Even if you think Jamie Dimon is a fantastic guy, and a savvy businessman, whatever the president said about him, which I'm not taking a side on. Jamie Dimon will not be running J.P. Morgan Chase forever. He's already lining up his successor, in fact. Whatever you think of John Reed and Sandy Weill at Citi, the fact is, they were succeeded by Chuck Prince, who was a disaster.

Every business eventually falls into the hands of somebody who doesn't know what they are doing. That is particularly true in finance, and it is particularly true at big financial institutions. So I think it's safe to say Jamie Dimon is the most dangerous man in America.

ZC: There is a very strong culture of hero worship in finance, not just on Wall Street but in the Federal Reserve. People view the Fed Chairman as this great golden god who descends from the clouds to speak to the monetary multitudes.

SJ: Yes, he's like the adventure hero in some King Kong movie.

ZC: At least with Alan Greenspan, and the way his reputation has changed so dramatically in the last three years, is it safe to say that this idolization is a bad thing?

SJ: This is sort of a secondary point to our main theme, but Federal Reserve reforms are very important. There should be term limits on the Fed Chairman and the Fed Governors, and you should change the Sunshine Act to the extent that it applies to the Fed. The Sunshine law says that if you have more than three Fed Governors meeting at any time, it has to be subject to public notification.

Over the past few years, Ben Bernanke, Donald Kohn, and Kevin Warsh were the inner core, and everyone else was basically ignored, and to be honest, not that important. That's a mistake. It feeds into this whole policymaker-as-hero idea which is very dangerous in a democracy.

ZC: You've mentioned Citigroup a few times. What should Robert Rubin do with all of his money?

SJ: Robert Rubin is the most interesting person and the most important character for the country to understand in this crisis. What he thought, when he thought it, why he pursued these deregulatory policies when he was at the Treasury during the 1990s, what he was doing or dreaming about when he was supposedly in charge of governance at Citi. The way he viewed the world, and the way Greenspan viewed the world, is largely responsible for what just happened. How that has changed, if at all, is very important.

ZC: I'm not a fan of his policies at Treasury, but whatever you think of them, he was one of the few people who stayed on at Citi for the entire mess.

SJ: And a figure who has slipped below the radar. But here's what he should do with his money. My kids love Colonial Williamsburg. And I think Rubin needs to take a page from John D. Rockefeller here and go out and restore some historic banking place and create a living museum where people can go around and learn about and wear the clothes of people from this crazy era. I'm being a little facetious here with Williamsburg, but my daughters like to wear the clothes of 18th-century Virginians. But some place where you could wear the clothes of 1990s American bankers, and play in financial markets and make them crash. That'd be wonderful.

ZC: But this lesson about financial crashes seems to get unlearned every few years. One of the more obnoxious things Jamie Dimon said before the Financial Crisis Inquiry Commission was that remark about how financial crises happen every five to seven years, and we should stop being surprised by it and stop trying to prevent or contain it. But why does it keep happening? Why can't people remember that markets often get out of control and crash?

SJ: Oh that's hooey; they remember. The problem is that they have incentives to do it again. The Chuck Prince quote that we all make fun of--"While the music is playing you've got to get up and dance"--is actually 100 percent correct. It totally encapsulates what is wrong with Wall Street now and what was wrong with Wall Street before. Remember, he said that in July 2007 just as the wheels were starting to come off the bus. The insanity couldn't continue forever, but everybody was getting rich by pretending it could.