The Hopeful Science
Creating the Next Crisis
Simon Johnson
|
|
|
|
WASHINGTON, DC -- Informed opinion is sharply divided about how the next 12 months will play out for the global economy. Those focused on emerging markets are emphasizing accelerating growth, with some forecasts projecting a 5% increase in world output. Others, concerned about problems in Europe and the United States, remain more pessimistic, with growth projections closer to 4% – and some are even inclined to see a possible “double dip” recession.
This is an interesting debate, but it misses the bigger picture. In response to the crisis of 2007-2009, governments in most industrialized countries put in place some of the most generous bailouts ever seen for large financial institutions. Of course, it is not politically correct to call them bailouts – the preferred language of policymakers is “liquidity support” or “systemic protection.” But it amounts to essentially the same thing: when the chips were down, the most powerful governments in the world (on paper, at least) deferred again and again to the needs and wishes of people who had lent money to big banks.
In each instance, the logic was impeccable. For example, if the US hadn’t provided essentially unconditional support to Citigroup in 2008 (under President George W. Bush) and again in 2009 (under President Barack Obama), the resulting financial collapse would have deepened the global recession and worsened job losses around the world. Similarly, if the eurozone had not stepped in – with the help of the International Monetary Fund – to protect Greece and its creditors in recent months, we would have faced further financial distress in Europe and perhaps more broadly.
In effect, there were repeated games of “chicken” between governments and major financial institutions in the US and Western Europe. The governments said: “No more bailouts.” The banks said: “If you don’t bail us out, there will most likely be a second Great Depression.” The governments thought briefly about that prospect and then, without exception, blinked.
Creditors were protected and financial sectors’ losses were transferred to the domestic government (as in Ireland) or to the European Central Bank (as in Greece). Elsewhere (the US), the losses were covered up with a great deal of regulatory “forbearance” (i.e., agreeing to look the other way while banks rebuild their capital by trading securities).
And it worked – in the sense that we are now experiencing an economic recovery, albeit one with a disappointingly slow employment rebound in the US and some European countries. So what is the problem with the policies of 2007-2009, and why can’t we just plan on doing something similar in the future if we ever face a crisis of this nature again?
The problem is incentives – what bailouts imply for attitudes and behavior within the financial sector. The protection that was extended to banks and other financial institutions since summer 2007, and more comprehensively since the failure of Lehman Brothers and AIG in September 2008, sends a simple signal. If you are “big” relative to the system, you are more likely to get generous government support when there is system-wide vulnerability.
How big is “big enough” remains an open and interesting question. Major hedge funds are presumably looking for ways to become bigger and take on “systemic importance.” Ideally – from their point of view – they will bulk up without attracting regulatory scrutiny, i.e., no ex ante limits on their risk-taking activities will be imposed. If all goes well, these hedge funds – and of course the banks that are already undoubtedly Too Big to Fail (TBTF) – get a great deal of upside.
Of course, if anything goes wrong, everyone who is TBTF – and who has lent to TBTF firms – expects to receive government protection. This expectation lowers the cost of credit for megabanks today (relative to their competitors, which are small enough that they are more likely to be allowed to fail). As a result, all financial institutions gain a powerful incentive to bulk up (and borrow more) in hope of also becoming bigger and therefore “safer” (from creditors’ point of view, not from a social perspective.)
Top US policymakers acknowledge that this structure of incentives is a problem – interestingly, many of their European counterparts are not yet willing even to discuss these issues openly. But the rhetoric from the White House and the Treasury Department is “we have ended TBTF” with financial reform legislation currently before Congress and likely to be signed by Obama within a month.
Unfortunately, this is simply not the case. On the critical dimension of excessive bank size and what it implies for systemic risk, there was a concerted effort by Senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks – very much in accordance with the spirit of the original “Volcker Rule” proposed in January 2010 by Obama himself.
In an almost unbelievable volte face, for reasons that remain somewhat mysterious, Obama’s administration itself shot down this approach. “If enacted, Brown-Kaufman would have broken up the six biggest banks in America,” a senior Treasury official said. “If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.”
Whether the world economy grows now at 4% or 5% matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout – and is not now facing any kind of meaningful re-regulation. We are setting ourselves up, without question, for another boom based on excessive and reckless risk-taking at the heart of the world’s financial system. This can end only one way: badly.
Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, http://BaselineScenario.com, a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
For a podcast of this commentary in English, please use this link:
http://media.blubrry.com/ps/media.libsyn.com/media/ps/johnson9.mp3
You might also like to read more from Simon Johnson or return to our home page.
|
|
Tyranosopher 05:20 16 Jun 10
It is not just a question of the next crisis. It is a question of the institution of a two track system: really worthy individuals are serviced by the state, and the People, in such a way that the rest of society, and of the economy are left destitute. The civilizational purpose for banks, investing saved money, and creating money for the worthy projects in the real economy, have been turned upon their heads.
Instead the system has been perverted to create a new aristocracy.
One has to distinguish the banks, as institutions to be saved, and the top officers of the holding companies of these banks, who, in conspiracy with said officers, manipulated the notions of risk and even profit, so that they could get ever more power for themselves and their attending puppets in politics.
Once the People paid for the banks, as it did, the People ought to have owned them, change their management, and force them to lend to the real economy, instead of doing fake trading among themselves in conspiracy with the government, to show what are fake profits. Those profits are fake, because the fiduciary duty of banks, in the fractional reserve system, is to create money for the real economy, not profits in the derivative universe.
http://patriceayme.wordpress.com/
PA
DejaVu 07:14 16 Jun 10
Dear Mr. Johnson,
But you are wrong on TBTF, you've never addressed the situation of the Canadian economy which was dominated by a handful of large banks, and the fact that these banks did not require any bailouts or support from the government during the last crisis. As Paul Krugman says, you regulate what banks do, not how big they are.
Your complete misunderstanding of this issue has helped ruin the financial reform effort here in the States by distracting policymakers from the real task of financial reform: restoration of Glass-Stegall, putting all OTC derivative activity on exchanges, etc.
Also, since you and Mr. Kwak are deficit hawks, both of you were extremely important in getting the G20(among others) to call for immediate fiscal austerity. As the world shall see very soon, these stark, raving mad policies of fiscal austerity which were demanded by you and being implemented now, will percipitate a Second Great Depression.
Congratulations on a job well-done! You're starting to make Jeff Sachs look like a good economist, something I thought would be next to impossible to do.
aspray 12:02 17 Jun 10
DejaVu,
Even though it's far from Glass-Steagall (which is a necessary reform in my view too) Would you agree that breaking up banks that are too big to fail does get at the same category of issue? Both measures attempt to break up linkages that cause systemic risk. Companies that are too big to fail easily tie up a large portion of the economy's assets in very risky activities (as we've seen). Then, if they are too big, when these bets go south, over-leveraging can become a sovereign debt problem.
I am completely for disconnecting risky derivatives from banking (if we don't, double-dip is a sure bet), however, I'm not sure if we can be assured that we can stave off future crises in the banking sector. And when the next type of crisis hits, it would be nice to have a greater chance of isolating it.
Also, when I talk about sovereign debt, I don't mean that we should kill deficit spending now, rather that sovereign accounts would be in much better shape if such big bailouts could have been avoided. (Would this crisis have even happened if banking hadn't been in bed with investment and insurance?)
The one good argument I've heard against the too big to fail idea is that even splintered financial markets (with many small actors) follow herd behavior terribly, so what would have stopped many small actors from necessitating big bailouts of the sector?
PKurowski 02:29 17 Jun 10
They are not creating the next crisis because for that they would have to get out of the current one; which will not happen if they persist on such nonsense of allowing banks to lend with very low capital requirements, zero to 1.6 percent, to fancy sovereigns and triple-A privates, while requiring them to hold 8 percent when lending to the natural clients of the banks, those small businesses and entrepreneurs that need to be nurtured while on their ways to the capital markets.
Dightster 03:06 17 Jun 10
Let's just hope the power bokers have moved on from the dark ages of the Reagan government when Ronald famously said " ... I'm not worried about the deficit ... it's big enough to take care of itself". If it was only that simple.
aspray 04:47 16 Jun 10
It appears to me that the current legislation in consideration is focused on preventing the next bubble by treating the cause of this one, Examining incentive schema to better regulatory enforcement and increasing transparency in derivatives, and not on creating a system that can respond to the next bubble's burst. After all, if we have learned anything about financial markets in the past several hundred years it is that there is always a next bubble. If we want to avoid the same sort of systemic shutdown we experienced in the Credit Crisis, we have to create a more adaptive system. Compartmentalize risk so that losses don't bring down the system, in effect, please break apart banks that are too big to fail.