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PERMANENT LINK | NOVEMBER 28, 2011
Simon Johnson on the Financial Crisis
Simon Johnson
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Simon Johnson of MIT and the author (with James Kwak) of 13 Bankers talks with EconTalk host Russ Roberts about the origins of the financial crisis and how the next one might be prevented. Invoking the work of George Stigler, Johnson argues that the financial sector has captured the regulatory process and the result is that regulation and government intervention have been steered more by the interests of the financial sector than to the benefit of the general public. Johnson argues for capping the size of banks in order to reduce the danger of systemic risk and the too-big-to-fail excuse for bailing out banks. Johnson also discusses the role of the Fed in subsidizing risk-taking and leverage in the financial sector.
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Readings and Links related to this podcast
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About this week's guest:
About ideas and people mentioned in this podcast:
Books:
Articles:
- "Looting: The Economic Underworld of Bankruptcy for Profit," by George Akerlof and Paul Romer. Brooking Papers on Economic Activity, Vol. 1993, No. 2, (1993) NBER Working Paper Version.
- "What is Systemic Risk and Do Bank Regulators Retard or Contribute to It?," by George Kaufman and Kenneth Scott. The Independent Review, Volume VII, Number 3, Winter 2003. Discusses whether Continental Illinois actually posed a systemic risk.
- "Too Big to Fail is Simply Too Big," by Jon Huntsman. Wall Street Journal, October 19, 2011.
- Federal Reserve System, by Richard H. Timberlake. Concise Encyclopedia of Economics.
- Financial Regulation, by Bert Ely. Concise Encyclopedia of Economics.
- George Stigler. Biography. Concise Encyclopedia of Economics.
Web Pages:
Podcasts and Blogs:
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Highlights
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| 0:36 | Intro. [Recording date: November 21, 2011.] Our topic for today is the financial crisis and your book, 13 Bankers. Let's set the stage: What changed in the last 3 decades or so in the relationship between the American economy and the financial sector? Because the financial sector recently--before the crisis and in the run-up to the crisis--played a very different role in the economy than it had before. What was different? That's exactly the right way to come at this issue. For 150 or so years in the creation of the American republic and the creation of the greatest industrial power the world's ever seen, finance was not particularly a critical sector. We certainly didn't rely on big banks. And after the Great Depression, banking was quite tightly regulated in the United States. I think it played a particularly healthy role in financing entrepreneurs, creating venture capital, sector and so on and so forth. But from the 1970s it really changed dramatically, because the banks became bigger; they were able to take on more risk; and eventually they were able to blow themselves up, at great cost to society. Their profits increased dramatically over that time period--their profits as a share of the economy, their role as an employer increased, although not quite as dramatically. Why did that change? What do you think we understand about that transformation? And certainly, as you point out: Banking was a steady, important part of the American economy before this period. But something changed dramatically in the 1970s, 1980s, 1990s, and 2000s. Why did that happen? I think the best symbol of what changed was in the early 2000s, when profits were 40% of total corporate sector profits. And that was obviously a misstatement, because subsequently they ran up big losses. You don't go back and reduce that profit in an actual account. But the big issue was everyone would take on risks. So, you take a lot of risks now, you show the upside, you pay yourself a lot of money, and then the downside gets shoved onto the taxpayer one way or another. So, it's the ability of the financial sector. You need finance to take risks, to provide equity investments and sometimes provide debt investment to entrepreneurs and that's fine. But the financials went way beyond that in the past couple of decades. They developed an ability to take risks at the macroeconomic scale and risks that really have no counterpart in terms of benefits for the economy. We are not getting better allocation of capital. It looks a lot worse, actually. Right now it looks terrible. Of course, we are trying to come of a pretty deep recession, so it's hard to be sure. But you can't make the case that the allocation of capital improved in the 2000s or 1990s compared to where it was in the 1950s and 1960s. When I look at that I always point out that putting trillions of dollars into housing is probably not the most productive use of scarce capital. As you say, it's hard to say. I try to take a pretty agnostic view. If genuine markets allocate capital one way, I feel that's sort of their business and I'm happy with the market outcome. If it's a matter of government subsidies pushing capital toward housing, which is obviously what happened in part, and then the private sector rides the cycle with massive leverage and risk taking for private benefit, then we have a problem.
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| 4:46 | The two views of this expansion of the financial sector: One view is that they do mostly allocate capital wisely and we should trust what they do because they have a profit incentive; the other view over this time period was they don't do anything. They don't make anything. All they do is speculate and push pieces of paper around. And I have to confess that I was always on the side that said they are looking out for their profits; and of course if that's what the market signals them to do, that's going to be okay. What I neglected was the loss side that we insulated the financial sector from, and that is clearly part of the problem. Absolutely. I think of myself really as a follower of George Stigler. Stiglerian, perhaps? Stigler's point was that when you regulate industries, the industry will turn around and capture the regulation; in utility pricing, you get inefficiencies of various kinds, for example. But for banking, which wasn't Stigler's focus because banking wasn't a big issue when he was doing his work, it's much worse. The banks can turn around, capture the regulations, get themselves permission to take on all kinds of crazy risk. Great private benefits. In this case it seems like it was mostly for the management, not even for the shareholders. But the shareholders thought they would, and certainly some of them did if they got out early. There was a lot of volatility for them to take advantage of if they did the timing right. Good point. So, the shareholder calculations always have to take that into account. But if you look at buy and hold shareholders of the past 20 years of the big banks, they've not done particularly well. At a time when people who built up those big banks and ran them as their growing empires did incredibly well on a cash basis. The regulatory capture--interesting example in this particular case that I think has been a little bit misunderstood. Part of it hasn't been detailed very well, and I think you do the best job that I've seen, in 13 Bankers, and we're going to come back to that capture and deregulation that helped banking. But I think the weird part about this is that on paper, it didn't look very much like capture because "all the bankers got permission to do was to be highly leveraged on very safe things." And that seems to be okay. If you said on paper in the abstract: Should banks be allowed to borrow more, to use less capital in areas where they are investing in safe things? Well, that makes sense. That was the basis for Basel I and II, to say, well, if you are investing in triple-A, which is safe, then it's okay. But what was neglected was the ability of the financial sector to create triple-A. At the time, triple-A was scarce. So, they said: Well, we'll fix that. If that's the thing that we are able to run wild on, okay, fine. I view this as a really depressing bit of entrepreneurship on the part of the financial sector; and again, those of us who are market oriented I think defended that wrongly at the time by saying: This is innovation, giving people more access to housing. We didn't realize that the downside risks were being protected for the banks and therefore they were acting very recklessly. I think that it. You just described one of the most sophisticated regulatory capture schemes in the history of human kind. Not saying there was a conspiracy, not saying they set out to do it; but that is the way in which competition pressed them forward, I suppose; and Basel in my view is absolutely part of the problem. Because if you take the position that somebody can tell you what's risk free--and I don't care if it's a regulator or a banker or an academic--I don't believe them. Your point about manufacturing risk free assets is correct at least about the American system. But look at Europe today. It's triple-A, formerly known as triple-A sovereign debt that is at the heart of the problem there. And by the way, a lot of our problems over the last few years may end up in the history books as being the forerunner, the lead up to, the really big crisis, which is the European sovereign debt crisis. Because we've never seen a crisis on this scale for "safe" debt. Not in the modern period. I think your point is the right point: There's no such thing as safe debt. I think everybody who plays in this world understands it. They may forget it from time to time, and we may reduce their incentives to remember it; but everybody understands there's no such thing as a risk free asset. So there was sort of this illusion fostered by political and economic forces that these were safe things. It's not that they were safe things to invest in. That's a mistake and if you turn out to be wrong, you pay a price--you lose your money. The real problem is that they were safe things to invest in with a lot of borrowed money rather than one's own capital. If you risk your own capital and you lose it, you lose; you have a bad quarter or a bad year; maybe you are wiped out. The problem we are dealing with now is that we allowed, we encourage the use of leverage to finance this, which is what is going to create the mother of all storms. Absolutely. And of course it's not just leverage. It's the scale. So we might distinguish between what we could call the John Corzine problem and the Chuck Prince problem. John Corzine--MF Global--that's the view of sovereign debt being safer, and if MF Global failed, $40 billion dollar balance sheet, who cares. I looked quite carefully around the world; you can see barely a ripple from that failure. Chuck Prince famously bet massively on mortgage backed securities and said you've got to keep dancing as long as the music is playing. At the moment he said that, I believe the music had already stopped. He was the head of Citibank; and that was a $2.5 trillion balance sheet that went down; and was saved by the U.S. taxpayer on incredibly ridiculously generous terms. People do make mistakes sometimes and get carried away and there's plenty of hubris in and around Wall Street. That's fine. But why would I want one guy or a small set of guys to control $2.5 trillion dollar balance sheet, and getting bigger--because these guys want to get bigger--to be able to bring down a big chunk of the economy like that and have massive damage?
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| 11:22 | We're going to come back to what can be done about that, but before we do that, I want to go back to the history lesson, because again I think people on the right--and this would include myself; I'm not on the right but I'm a free market type so people put me on the right--the right's very skeptical about this idea that deregulation is the source of the problem. And they say: What deregulation are you talking about? The financial sector is one of the most highly regulated industries in the American economy--which is true. But what can you point to, and one of the things people point to is the Gramm-Leach-Bliley Act (GLB)--which is a very hard thing to say--which is the repeal of the Glass Steagall Act. Was that important? I think so, at least a little bit; but I think one of the subtler things that you highlight in the book. Talk about the deregulation and what was important that allowed the Wall Street investment banks to grow so large. It was a process of, you could call it deregulation, or the changing nature of deregulation. The banks are still highly regulated and have been throughout this process, but the restrictions implicit in this regulation on large scale risk taking, those restrictions receded. The end of Glass-Steagall is a symbol, but at that point a lot of the restrictions on big banks have gone away. I would point rather at the sale or the reluctance to have a proper regulatory framework for derivatives, not traded in open markets or over the counter. I think that's important. But even bigger than that was the decision by the Bush Administration, by the Securities and Exchange Commission (SEC) to allow investment banks to massively increase their leverage, based on just their own internal assessments of what kind of risks they would take. You look back and in terms of the big mistakes in financial history, that's got to be in the top 10. And then you've got just the lack of--sometimes deregulation, sometimes change--the whole phenomenon that allowed the security market to expand. And my favorite--this is just a beautiful piece of detective work that you describe in the book--in 1991, which is 17 years before the crisis explodes, Goldman Sachs lobbied to change I think three or four words in a piece of legislation related to the Federal Reserve, which was that the Federal Reserve could open its window only to banks whose assets were based on commercial transactions. Describe what happened there. Goldman Sachs wanted better, more of a backstop, ultimately for itself; and this is exactly the issue of downside risk. If the assets fall in price or any investment. In the modern economy we run a fiat money system; any central bank is a very appealing place of last resort. Goldman makes essential progress then, and later, but still needed to become a bank holding company in September of 2008 in order to really be saved. And that's how they operate today. Full backstop from the Fed. But in the absence of that 1991 wording change, that conversion would not have been sufficient. Is that correct? That conversion to a bank holding company would not have been enough? Yes. At least that's our interpretation--that they were very thoughtful and prepared long ago for this kind of eventuality. These are very smart people. This view that says they were just stupid, that they drank the KoolAid, they believed their models--I'm sure as you pointed out earlier there's a lot of hubris and overconfidence, but smart people tend to be aware that things do fall apart sometimes. My claim is that the incentives to be careful about that are what disappeared. I'm sure you are right. And if you go back to the original debate about the founding of the Federal Reserve, at that time we had relatively late compared to most countries; and we also had a relatively open debate; most countries sort of stumbled into modern central banks. Two views of the downside or the drawbacks of having a central bank: one was Nelson Aldrich, of the establishment, which said this will create moral hazard problems for government and that will lead to inflation. On the other side was the Peugeot Committee and Louis Brandeis, before he became a Supreme Court Justice, who said: Well, there's also moral hazard this will create for the financial sector. Because the Wall Street barons, oligarchs, will be able to draw on this credit when they need it; and that will encourage them to take excessive risks. I have to say, looking back over 100 years, the experience of many countries or the experience of Europe today in the Eurozone, there are many instances like that of Greece who have proved Nelson Aldrich is right; but there are other instances, most spectacularly recently that of Ireland, that prove Louis Brandeis was also right. Describe--talks about Greece and Ireland and how those countries illustrate those two views. It's two types of moral hazard--not being careful, over-borrowing. And the problem is the markets, you could say, encourage you or the don't warn you that you are getting close to over-borrowing. So, Greece ran big budget deficits, didn't do sensible fiscal adjustments, papered over the cracks; also it seems helped by some deals that concealed the true nature of their indebtedness until it was a bit too late. But that's the government over-borrowing, and that's made possible by a financial sector that has incentives for example to hold "risk-free" government debt. Never risk free. There's a second set of problems though--in Ireland, almost entirely about the private sector. The government was running a low deficit, actually surpluses; debt-to-GDP was low, in the 20% range, lower than most other industrialized countries. But three big banks increased their balance sheets, took a lot of risk, combined were two times the size of the Irish economy. They blew themselves up on bad commercial real estate, largely, residential real estate. That caused so much fiscal damage to the Irish government that they were forced to go get a loan from the International Monetary Fund (IMF) and the European Commission. So, for Greece, the government's gone wild; Ireland, the damage is done by bankers gone wild. It's the same difference, and that's the original Aldrich-Brandeis combination of points. When you have a central bank, when you have a backstop, when people think they are going to be bailed out, they are not careful.
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| 18:21 | Now in 2008 American policy makers made a series of decisions which I view helped create the current mess we are in now, in the aftermath of that, and certainly raised the chances of future crises. One of those decisions was the guarantee the assets of Bear Stearns to allow their creditors to lose zero, which sent a signal to markets, which was: Keep going, keep dancing. There was a decision not to rescue Lehman Brothers, which has been interpreted I think somewhat incorrectly as the source of the problem. That in turn was followed by a series of relentless rescuing. AIG--every AIG creditor got to keep all their money, including obviously some large politically powerful organizations. And then finally the Toxic Asset Relief Program (TARP), hundreds of billions of dollars into the balance sheets of banks, on the grounds of keeping banks in health to avoid a crisis. The TARP was kind of the punchline of that period. What might have been done differently? What other options should have been on the table? In all those cases, by the way, there was almost no debate, even among so-called experts, at the time; certainly for Bear Stearns people said: We had no choice. I disagree, but that was the common consensus. TARP, there was a debate about exactly what might be done with the money. But if you had been in charge--dream for a minute--what would have been done differently at those checkpoints. Good question. I think the key in all these situations is that you want creditors to face a lot of risk. Maybe not huge losses, certainly not losses that would be catastrophic and have big spillover effects to the rest of the economy. And you would like them to know what their losses are up front so they don't have to worry about the uncertainty. For example, Lehman is still not entirely settled, people are going to get out. It looks like about 20 cents on the dollar. Right, but it takes you three years to get to that--uncertainty. I think as you alluded, some losses for the creditors of Bear Stearns would probably have been a good idea. Not saying that would have nipped this thing in the bud but it would have given people the incentive to slow down. And certainly in the TARP and post-TARP bailouts--of course there are more programs; there's also all the guarantees provided by the Federal Deposit Insurance Corporation (FDIC) and there's all the asset support actions taken by the Federal Reserve one way or another. All the windows they opened. You need to have change of control. You can't keep the same management running the banks when you are saving them. You need to change boards of directors, you need to change executives. When you've decided that it's systemic, of course, you can't change all management in all the banks; but I think that's something of a smokescreen, and really at the biggest banks they should have had a change in management, a change in the boards of directors. Whether you could have had credit take a hit in the late fall 2008, early spring 2009--that is debatable. I think that's the danger going forward, that you find yourself in a situation where well-informed people believe that it's the choice between global calamity or bailout. That reminds me of this moment in the crisis when I think Hank Paulson and maybe Tim Geithner came to George Bush II and said: We have to bail out AIG. And Bush supposedly said: Well, it's regrettable but I accept your point; we have to do it; how did we get to this point? How did we get to a world where that's our choice--global calamity or unsavory bailout--he didn't phrase it that way, he said it a lot better--but that's a very unsavory choice and obviously you want to avoid having to make that choice. And of course faced with that choice, policy makers almost always choose unsavory--bailouts of cronies--which I think is really destroying perceptions, correctly so, of the fairness of the system. Absolutely. The unsavory bailout is one thing; but as you say, it's the cronies, the people who are very highly connected to the President of the New York Fed. Mr. Geithner, people he socialized with, people with whom he was on board; and of course people he knew had spent a long time on the phone with in early 2009. Now, that's a perception problem for sure; but the reality is also pretty bleak in modern American context. And the criticism of banks--you look back historically, look at the various ways of critiques that we've had. Sometimes the people who criticize big banks for their actions at the time are called populists. If you look at the history books, they are the ones who look like the sensible people who are just calling for restraint and responsibility.
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| 23:49 | So, one of the views of this 30-year period of banks' ascendency and political influence, which led to this either deregulation or lack of regulation; and I think equally importantly a willingness of government to intervene on their behalf, which is why I refuse to accept the standard argument you hear sometimes which is that this was a triumph of rightwing ideology--Alan Greenspan gets blamed for this because he wouldn't regulate derivatives. Well, that's true; he wouldn't. But he also was eager to bail out creditors in the Mexican crisis; he was eager to keep Too Big to Fail on the books because he felt that enhanced the power of the Fed, in my opinion; he was eager to manipulate interest rates; and he was eager to orchestrate a rescue of Long Term Capital Management (LTCM). So, he's not a free market ideologue, unless it was useful to the cronies. It's just a bizarre myopia, or blindness, to call that free market. It's not. I agree. It was known as the Greenspan Put for a reason. It's funny or interesting; Greenspan has an essay from I think late 1960s when he was something of an advocate of the gold standard, where he, I think, lays out--I'm not a gold standard enthusiast as he was then, but the point he makes there that when you have unconditional support available from the central bank and you use it, which you can do under a fiat money system more readily than you can under the gold standard--and this of course was Brandeis's point in the original Federal Reserve debate--when you have that power, that is a form of what sometimes people call Statism. And you are putting power in the hands of the State. Now, I'm a very cynical person. I think everyone is out pursuing their own interests. I don't think there are idealistic people running the State. I think there are a bunch of guys who have some friends and they are trying to help themselves and perhaps they think this is good for the economy. I don't know. And for sure, Greenspan had a point there, that the kinds of actions he later engaged in, are favoring a relatively few people. And benefits are not shared more broadly. This is not a good model; we know that from various systems around the world. But Greenspan proved that that same philosophy can fail spectacularly, even in the United States. You mentioned the opportunity we might have had to remove management. One view says: A lot of management was removed. Jimmy Cayne at Bear Stearns lost his job, Richard Fuld at Lehman lost his job, Angelo Mozilo at Countrywide lost his job. A lot of people did get removed by something like market forces. And then the question would be: If you want to do that more systematically, what would be the mechanism? We've talked briefly on the program about the FDIC Improvement Act, what's called FDICIA, of 1991, which at the time was supposedly a way of avoiding this moral hazard, too big to fail problem. And it was never used, or very little used, in this crisis. Do you think it could have been used? What mechanisms might have been available for more punitive interventions with management? Well, first of all, what I'm suggesting is not punitive. I'm suggesting sensible managerial procedure. If you buy a company, a troubled company; you are a private equity fund; for sure you do not keep the Chief Executive Officer (CEO) in place. I've never heard of that. You fire the guy. And secondly, perhaps they could have used that legal authority, perhaps not; but tell me this: What's the legal authority that allows the U.S. government to fire the CEO of General Motors? [more to come, 27:34]
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Hi Russ,
With regards to the ending of the Fed would you consider competing currencies a good idea instead of mandating the Fed to be dissolved? I am not saying this is what you suggest.
It doesn't just have to be gold and silver we have Bitcoins, as described in the earlier podcast to name another. Europac also has a credit card that can be backed by metals as well but it is based on an off-shore account since oddly enough it appears to be illegal to have a monetary vehicle backed by gold based in the US (and many other countries).
It seems obvious as to the mischief, outright dangerous, cronyism practiced by those with political connections - It is time we DEMAND that the Fed eliminated. I could not help feel powerless against forces arrayed against little old me as I navigate the system - The game is all set - against me. People play to win and when they lose, they go for handouts - and get them.
I do not have any doubt that the ECB will bail out their friends (Big Banks) that have lent to "AAA" rated Sovereign Funds ...
The question I had was - Where is the US today? With 15 trillion dollars in debt, with our Fed lending to anyone in any part of the world (if they are their friends) - What happens if we continue borrowing and not help growth?
Russ-
I'm always astounded why *anyone* listens to Simon Johnson. This gentleman was Chief Economist at the IMF from March 2007 through August 2008. Why was he not banging the drum about unsustainable lending practices in the mortgage industry, or how sovereign debt in the European periphery would threaten the Euro and the global financial system with it?
Did he shout this from the housetops? No, he did not. He didn't because economies are complex and not conducive to discussions of mendacity, greed, power plays, and good/evil dualities that sell books and make for good copy in the elite news-media world.
Simon Johnson sounds great and seems to have all the answers. But its astounding how few of them were readily apparent to such an intelligent man when he actually was in a position of responsibility at one of the more important global financial institutions on the map. Of course, just about the only people shouting "fire" at the time were the ones who always shout fire, the perma-bear broken clocks that are right twice-a-day.
But no one ever asks Simon about his role. No one asks why he didn't write "13 Bankers" in 2006, when the world could have used it. In other words, if he's so smart, why isn't he rich? Or why is the rest of the world so much poorer now, than it could have been if it had only listened to the wisdom of The Expert from MIT?
But you gave him a pass because he laughed at your James Grant joke. Could you please ask some harder questions next time, about agency issues and self-interest? At least Gary Taubes acknowledged his own internal biases.
Gents:
That was a GREAT discussion of the banking problem. I loved the insight about the problem with shortage of AAA. I just happened to read a Felix Salmon blog questioning why the fuss over the big banks speculating. His suggestion (in the context of "Margin Call") was that they were not taking money from the "99%" but rather they were simply pilfering from other banks. How a guy could view 0% interest rates in perpetuity, bailouts that dwarf the TARP, and massive flows of funds to Europe under a thick veil of secrecy (sort of) could be so benign.
I got into it with the former head of fixed income at Bear Stearns about whether it is criminal to screw up on the scale that they continue to screw up on. I argued that it was like a doctor who went to extract a kidney and took out the liver instead. That guy is in trouble. If it was found to be done out of profit motive, that guy is looking at a noose. Wall Street should be careful about avoiding an orderly cleanup, because disorderly variants are much worse.
Again, thanks for the discussion.
Dave
[correction made per commenter--Econlib Ed.]
BTW-Although I am still a tweetard (rookie tweeter), I was successful at "retweeting" it. Proud tweeter.
1st "all the bankers got permission to do was to be highly leveraged on very safe things." And that seems to be okay.
No, that is not okay! If risk models, credit ratings and banker intuitions were perfect, then a bank would really not need any capital at all, since all risk considerations would have been correctly priced, in the interest rates, in the amounts and in the duration of the loans. But, since risk-models, credit ratings and banker intuitions are not perfect, the regulators should require the banks to hold some capital, to make sure that there is an adequate cushion provided by the shareholders who are profiting from the bank activity, before creditors and tax payers are called upon to help out. Agree?
Unfortunately, the current generation of bank regulators, stupidly (sorry, there is no other way to say it) did not base their capital requirements for banks on the possibility of mistakes, but on precisely the same risk models, credit ratings and banker intuitions being correct… requiring for instance minimal equity when the ex-ante officially perceived risk of default of a borrower seemed minimal.
And precisely there, where the perceived risks of default seem minimal, is where the risks for a systemic bank crisis reside, since what is ex-ante perceived as “risky”, does not carry in its DNA the possibility of growing into a dangerously sized exposure.
And so, instead of helping to cushion for the mistakes of the banks, the regulators, with their distortions, increased the probabilities of the mistakes being made, and their negative financial consequences.
And that they did by, for instance, allowing banks to hold only 1.6 percent in capital when investing in triple-A rated securities or lending to sovereigns like Greece, which implied an authorized leverage of 62.5 to 1, while requiring the banks to hold 8 percent in capital when lending to job creating small businesses and entrepreneurs, an authorized leverage of 12.5 to 1. And that they did by allowing the banks to lend to the “infallible sovereigns” against no capital at all, not even the sky was the limit.
And that is why we got those monstrous large bank exposures to what was ex-ante officially perceived as not risky, like triple-A rated securities and sovereigns, and that have ex-post exploded in the whole Western World.
2nd “the basis for Basel I and II, to say, well, if you are investing in triple-A, which is safe, then it's okay. But what was neglected was the ability of the financial sector to create triple-A.”
No, again no! Even of the credit ratings had been perfect it would still be wrong because they would have been excessively considered … in the numerator in terms of interest rates amounts and maturities and in the denominator in terms of capital requirements.
[Comment removed for policy violations. N.B. EconTalk does not republish email or links to unverified online publications of private email or any other private documents without the agreement of all parties involved. --Econlib Ed.]
Extremely insightful.
It is exasperating to police the errors of a non-expert discussing this topic, but among the most common mistakes he repeats are:
- Bank creditors were bailed out: Ask those unsecured lenders burned in WaMu, IndyMac, etc how much they enjoyed their "bail-out".
- The US banking system required a massive bailout: According to the FDIC, the US banking system earned pre-provision income in excess of loan loses in each and every quarter of the "crisis".
- The social costs of the "bailout" were large: The US Treasury made billions on the TARP it forced on banks. There may be some obscure social costs critics would like to include, but the US Treasury directly made billions forcing banks to accept highly preferential investments from Uncle Sam.
- Bank equity holders suffered surprisingly small costs: The share count of every US bank is massively higher than it was in 2007. Even banks that avoided imprudent loans and were profitable every quarter of the crises suffered from the same costs (e.g., Wells Fargo). To suggest that banks paid low costs is very strange.
- It is rational to engage in risk lending without regard to future loses: The temporary excess spread earned on risky assets is a pittance compared to the costs of dilution. As much as Prof. Johnson and Roberts agree that banks have a rational incentive to make risky loans, the reality is that good business, like Wells, JPM, and old BofA, had very low market share of these risky loans.
- Small banks are safer: This is empirically not true. The largest depository banks in the US, BofA (ex-Countrywide), Wells/Wachovia (ex-Golden West), JPM (ex-WaMu), Suntrust, etc all had above average credit performance through the crises.
- Bank management was insufficiently disciplined and remain in charge: Tell that to the CEOs of Countrywide, Wachovia, WaMu, Citi, AIG, Lehman, Bear, New Century, AHM, Indymac, and so on who were all fired and humiliated. Who is missing from Simon John Should Wells Fargo have fired their CEO even though they never posted a quarterly loss? Should Jaime Dimon have been fired in spite of avoiding the excesses of the housing market?
- Holding more equity capital has no social costs: Additional equity capital reduces the relative value of cost-free deposits. While Prof. Admati and Simon Johnson appear to agree, everyone familiar with branch economics know that free deposits received for their valuable dis-intermediation function have lower required return than equity. This disconnect is at least partially why the economy is so weak in spite of the the US banking system operating for over a year with higher equity to assets than at any point since 1941.
I have come to really enjoy Econtalk each week, but this one is an exception. Simon Johnson seems to be explaining things from the premise that the 2008 financial crisis is the result of the financial industry just deciding to make lots of risky investments and the problem was that regulators did not stop them. I apologize for my own biases, but if Mr. Johnson can't show more economic insight than this, I have better things to do.
I am hoping for something better next week.
It's seems the discussion is focused on the symptoms of the core issue. Isn't the core issue the impact of gov't housing policy on the private capital system and the use of GSEs to distort the mortgage credit markets? Further, TARP was not exclusively for banks. The "healthy bank" program was ~$200B and was structured as a preferred stock investment that had billions of common equity as a cushion for losses. Also, the Fed liquidity programs were offered to stop the global run that was occurring -- something that it was originally established to do. It would be wonderful if we could avoid gov't intervention but, as the 30's have shown, even a system with thousands of (small) banks can't prevent a run if the public panics. In the end, the core issue was gov't influence in the private markets (aka the barn door); whereas, most of the other problems discussed were the symptoms of that core issue.
"Ask those unsecured lenders burned in WaMu, IndyMac, etc how much they enjoyed their 'bail-out'."
Indeed, it is the selectivity of the bailouts that make them egregious. Only the systemically privileged (systemically dangerous) got the prop.
"According to the FDIC, the US banking system earned pre-provision income in excess of loan loses in each and every quarter of the 'crisis'."
They abandoned FASB 157 in a heartbeat, allowing the banks to mark everything to myth. Part of the problem we still confront is that we haven't a clue what is fact and what is fiction (what garbage is still on their balance sheets.)
"The US Treasury made billions on the TARP it forced on banks. There may be some obscure social costs critics would like to include, but the US Treasury directly made billions forcing banks to accept highly preferential investments from Uncle Sam."
The banks have been in a perpetual state of bailout, borrowing from the Fed for free and lending back to the Fed for the spread (Fed-Fed carry trade). My 0% return is still supporting the banks. TARP was a tiny fraction of the $15 trillion committed to the bailout (possibly more considering huge flows to Europe over the last two years shown most clearly by Bloomberg's FOIA suit). TARP was kabuki theater.
"The share count of every US bank is massively higher than it was in 2007. Even banks that avoided imprudent loans and were profitable every quarter of the crises suffered from the same costs (e.g., Wells Fargo). To suggest that banks paid low costs is very strange."
Although I won't give Wells the pass, collateral damage is huge in an event like this.
"The temporary excess spread earned on risky assets is a pittance compared to the costs of dilution. As much as Prof. Johnson and Roberts agree that banks have a rational incentive to make risky loans, the reality is that good business, like Wells, JPM, and old BofA, had very low market share of these risky loans."
These banks moved the mortgages through to the gullible. Some chose to keep their own garbage out of expediency and got hammered, but they all participated in the mortgage mills. (JPM seems to be least culpable, but has a derivatives book that will be a headline sometime in the future.) Wasn't it the CEO of BoA that made the fateful quote about having to keep dancing while the music is playing? Did he not admit that there was no shutoff mechanism short of a catastrophe?
"This [safer small banks] is empirically not true. The largest depository banks in the US, BofA (ex-Countrywide), Wells/Wachovia (ex-Golden West), JPM (ex-WaMu), Suntrust, etc all had above average credit performance through the crises."
The big banks would have been pink mist without bailouts. Their friends in high places and preferred status render them safer than small banks. Having powerful friends imparts safety.
"Tell that to the CEOs of Countrywide, Wachovia, WaMu, Citi, AIG, Lehman, Bear, New Century, AHM, Indymac, and so on who were all fired and humiliated. Who is missing from Simon John Should Wells Fargo have fired their CEO even though they never posted a quarterly loss? Should Jaime Dimon have been fired in spite of avoiding the excesses of the housing market?"
OK. You work for Wells (or are a Buffett fan). Wells got their share of bailouts, and I go back to my belief that reported profitabilities are suspect and will remain so until state-sanctioned bad accounting is eliminated.
"Additional equity capital reduces the relative value of cost-free deposits. While Prof. Admati and Simon Johnson appear to agree, everyone familiar with branch economics know that free deposits received for their valuable dis-intermediation function have lower required return than equity. This disconnect is at least partially why the economy is so weak in spite of the the US banking system operating for over a year with higher equity to assets than at any point since 1941."
I think the economy is weak, quite simply, because credit bubbles pull demand forward and unwinding credit bubbles purge this mess through reduced demand. I don't think it is about the banks at all. They will make loans when the time comes.
Moving on to the subsequent comment:
"Simon Johnson seems to be explaining things from the premise that the 2008 financial crisis is the result of the financial industry just deciding to make lots of risky investments and the problem was that regulators did not stop them. I apologize for my own biases, but if Mr. Johnson can't show more economic insight than this, I have better things to do."
That's not what I heard. The source of grotesque liquidity--the source of the Nile--were the central banks (Greenspan in particular.) I thought they (Russ in particular) did an excellent job of giving Greenspan appropriate credit for his role. They did not delve deeply into voracious consumption by the masses, but I find that particular angle is tantamount to blaming the mark rather than the hustler. You've got to put it on Greenspan's head and Russ did precisely this.
Another EconTalk podcast that discusses the Fed, the economic crisis and the GOP candidates' approach thereto, and not even a mention of Ron Paul. RP called the crisis before it happened.
Great podcast series, but once again disappointing that Ron gets no props. What gives?
I thought this podcast left a lot to be desired. Especially for long term listeners of econtalk this was a rehashing of old ideas and basically just Russ and Simon (who view the topics discussed very similarly) just patting each other on the back.
I would have much preferred Russ giving Simon Steven Kaplan's counter arguments that he voiced just a few weeks previously and letting Simon respond. For those that don't remember, here is Kaplan:
"But I don't think--the view that it was heads I win, tails you lose just doesn't explain it. Because these sorts of events have happened really through all time. You had the Panic of 1873, very similar, people losing their own money; 1907, people losing their own money; you had 1928, 1929 people losing their own money; and then you had 2007-2008, which looks a whole lot like those other episodes. My view on this, the capitalist system, for better or for worse you get these periods where people become, whether it's overly optimistic or they just decide to take on extra risk and then they get things wrong and then you get a big downturn."
It would have been nice to hear the very smart MIT professor respond to the very smart Chicago professor's comments.
Another obvious counter-argument that wasn't given is that the great depression involved hundreds (thousands?) of very small banks failing, which has been a major criticism of the "too big is the problem" argument.
Of course, the same episode has been used to criticize the gold standard, as Friedman and Schwartz argued that tight money due to adherence to the gold standard caused the depression. It's funny that Russ used that work for so long as the penultimate empirical work that changed everyones mind and now he's running from the conclusion.
Lastly, a lot of the central bank talk was just wacky. There was no mention of how tight money policy is affecting the current situation. Even if you don't believe tight money has ANY negative growth effects, the fall of prices 10% below trend has been a huge transfer from debtors to creditors. Further, a lot of people have argued that the ECB should be targeting higher inflation, which in effect, is making creditors take a hair cut.
I am sure relatively new listeners will find a lot to like about this podcast. Certainly, Simon is a great guest to have on, but for those of us who have been listening for quite a long time, it would be great to get deeper into these issues and hear really smart people defend their views against really well thought out counter arguments.
Charlie:
Is the monetary policy tight or the demand for credit low? (I would have said the latter but am open to persuasion.) As to the Great Depression's cause, I would not begin to spar with Friedman's work on this, but must say that in all of his public chatter, I have never once heard Bernanke blame the ultra loose monetary policy of the 20's. It seems so obvious that maybe he doesn't feel the need, but it is a convenient omission when his job description includes opening the spigots.
Dave
PS-I am both a new listener (maybe a year) and a veteran (went through almost the entire audio archive chronologically at Russ's suggestion. What was painful was having absolutely nobody to discuss the podcasts with.
Simon said:
True statement, but I fear he and many other so-called "experts" have a hard time coming to grips with the fact that bank runs and panics are a healthy check on fractional-reserve banking. The panics wouldn't exist if banks weren't printing more notes than they hold in gold reserves. Give me a break.
I suspect that the chaps who introduced AAA criteria into regulatory capital requirements thought it a good idea at the time and it would have been unreasonable for them to forecast the specifics of how that was abused in the CDO cubed world of 2008. However I note that Simon Johnson learns little from this and despite mocking the above as a contributory factor to the financial crisis suggests more tinkering with unforeseeable consequences of his own.. limit individual banks to x% of this or that economic variable. Is it not obvious that the private sector will learn clever ways to work around this to their advantage with unintended consequences?
I dont understand why there wasn't more discussion about the more obvious root of the problem being an elastic money supply and a fractional reserve system.
The 19th century saw the greatest period of real growth in history yet at Queen Victoria's death the gold sovereign (currency at the time) was worth more than at her birth... money INCREASED in value over this time putting paid to the premise that one needs expanding money supply to accomodate growth.
With a finite money supply or one bounded by the difficulty of physically expanding it, and no fractional reserve banking, it is arguable that we could not have a financial crisis such as this. Banks would be little more than warehouses or matchers of loans and deposits.
Wild swings in monetary and/or credit base could not happen in such a system and lead to the problems we see today. Even the canard that Spanish gold had a major influence is rather moot when you consider it only bumped up gold supply by a few per cent, which compared to today's practive of, in the case of the UK for example, bumping supply by 20% /GDP magnitudes is chicken feed.
Let's focus on addressing the cause rather than ameliorating the consequences with second and third order mitigants and band aids?
[Broken url removed. Please do not use the "@" sign in urls.--Econlib Ed.]
William B said:
"experts" have a hard time coming to grips with the fact that bank runs and panics are a healthy check on fractional-reserve banking.
Bank run is a market solution. Can be handled in the market with 20% capital ratio and careful loan underwriting.
True, but should be generalized. This is not just true for banking, but for all economic activities. All of the supposed "ills" or "failures" of Capitalism are simply market solutions to government imposed problems (called "solutions" by "experts", and funny how it works that those "experts" are usually paid by government).
Deposit insurance is the government solution. One of the major reasons that we need government insurance for bank deposits is so that government or government friends can easily borrow from banks. Deposit insurance allows bank managers to leverage up and offer those loans to government and its friends. And the market then attempts to fix this with a run not on a bank, but on the banking system. To this the government solution is central banking with fiat money, and there, problem solved. Now there are no bank runs, no runs on banking systems ... now the run is on the entire economy. This actually completes the government solution, because the crisis is so deep and so painful, that we have to give government complete power to do whatever it wants.
By the way, countries that are irresponsible in managing their financial affairs and end up bankrupt often do go through liquidation-type bankruptcy. But the bankruptcy proceedings are imposed with military means.
David B. Collum writes:
I agree completely!
"Too big to fail" gets back to how we can let a bank (or other business) fail if it's not so large as to be "systemically important."
My proposal is a progressive corporate income tax rate. Very low (zero) taxes on small profits, up to 100% tax on profits when they reach a threshold (1% GDP? 0.01% GDP)?
No stockholder is going to accept 100% of profits being taxed away, so stockholders insist on the company spinning off subsidiaries. Making it a progressive rate allows the clamps to be applied gradually as a business grows, encouraging earlier break-up, but not requiring it.
In conjunction with this, we'd need some rules forbidding interlocking directorates and/or management. It would do no good to have the same 100 top-executives running 50 different paper corporations for the purpose of splitting the profit below the tax ceiling.
I'd also like to require the tax to be on "profits before salaries" so as to discourage a company paying it's top executives so much that they stay under the profit threshold.
David,
"Is the monetary policy tight or the demand for credit low? (I would have said the latter but am open to persuasion.)"
I guess we run into language problems here that have been debated at length over the last few years. I have adopted the terminology of calling monetary policy tight or loose depending on a central bank target. If inflation (or nominal GDP) falls below target (or in a different context below the optimal target), policy is tight, if it rises compared to target it is loose. Some other people still argue for other meanings like monetary targets or intervention. In that terminology my argument would say "monetary policy is "loose" but not nearly loose enough, or expansionary (or accommodative) but not nearly enough."
To respond directly to your point, the central bank should be responding to changes in demand for credit to hit their target, so if the demand for credit is low, so what, if they don't adopt an expansionary enough policy to meet their target, monetary policy is too tight.
"I have never once heard Bernanke blame the ultra loose monetary policy of the 20's. It seems so obvious that maybe he doesn't feel the need, but it is a convenient omission when his job description includes opening the spigots."
Monetary policy wasn't actually particularly loose in the 20's. Over the 1920s the price level actually fell (deflation). Nominal GDP rose about .5% a year (avg. growth in the post war period is about 5%). Base money growth was very minimal.
You might check out this post from Scott Sumner for more:
http://www.themoneyillusion.com/?p=12111
Great interview. I am convinced more and more that Hayek is wrong and we DO know what we need to do to stabilize the economy. The problem is not an economic problem. It's a problem of politics. How do we do politics to get the best policy and not policy that favors those special interest with money and access?
It also convinces me that like no atheist in a foxhole their are no libertarians in a free market. If profit is always the bottom line the most efficient way to make profit is to monopolize and capture the politicians.
David Collum's comments illustrate an important necessary step that is never taken in these discussions: a step to a drawer to take out a calculator and speak numerically about these issues.
For example, David repeats the common conspiracy theory that the Fed's policy of paying interest on bank deposits at the central bank is a huge subsidy to the banking industry.
Well, thanks to unreliable regulators that recently have a very bad track record dealing with changes in liquidity, banks now have around $1.5 trillion in deposits at the Fed. So instead of lending at >4%, banks are forced to keep far more deposits at the Fed for a measly 25bps. Even with 15x equity/assets AND ZERO OPERATING COSTS (such as those branches that gather those deposits), 25bps gives an equity return about equal to CPI at 3.7%. So that subsidy allows bad policies to only reduce bank ROEs to CPI assuming that they have none of expenses every bank has? That is the generous subsidy?
As for scale, 25 bps on even $2 trillion of deposits is a whopping $5B of annual gross interest income for the entire US banking system. For context, that is less than a month's revenue at BofA. This is the huge subsidy: enough money to keep the lights on in US bank branches for a couple days. Or in an imaginary world where banks do not pay for those expensive branches, equity owners would get a juicy return equal to inflation. Sounds like a mega-subsidy to me.
Many claims fall to pieces when subjected to the rigor of a calculator. The numbers are out there; lets get our calculators out. If we can't, can we at least listen to people who have done the math?
[Typo in Collum's name fixed--Econlib Ed.]
"banks are forced to keep far more deposits at the Fed for a measly 25bps."
Banks aren't being forced to hold these reserves by regulators. They are choosing to hold these reserves.
Look at Excess Reserves:
http://research.stlouisfed.org/fred2/series/EXCRESNS?cid=123
It's almost $1.6 trillion, whereas the required reserves are about $100 billion.
Charlie:
You are correct; we have a huge difference in opinion about loose versus tight monetary policy. Where I would disagree would be that my judgement of their looseness has nothing to do with what they wish to achieve. I think that central bankers may be acting on a misguided belief that what they wish to happen should trump what market pressures are mandating.
One of my favorite books about the 20's and 30's is by Nelson, McManus and Phillips entitled "Banking and the Business Cycle" (1937). They do a beautiful job of showing how the Fed did everything within their power to loosen monetary policy in the 20s. They thought they won the battle against the post war deflation--it flatlined thoughout the 20s--only to find out that they had simply deferred it to the 30s. There were, however, three years in the 20s in which they plunged reserve requirements and other monetary moves explicitly designed to loosen markedly.
Dave
Bankerman:
Your point is well taken and mine was off target (overstated).
Dave
"Where I would disagree would be that my judgement of their looseness has nothing to do with what they wish to achieve."
Yes, much of the field still talks this way. It leads to statements that an outsider would consider very strange. They hear about how tight Volcker's monetary policy is and then don't understand why people can say that the inflation being endured is being caused by monetary policy that's too loose.
Now they hear about looser than ever fed policy and don't understand why economists are saying that a major problem is tight money. The same thing happened in Japan in the 90's.
"only to find out that they had simply deferred it to the 30s."
Bernanke thinks that the deflation during the 30s was caused by Fed policy decisions in the 30s, not decisions made in the 20s.
"Bernanke thinks that the deflation during the 30s was caused by Fed policy decisions in the 30s, not decisions made in the 20s."
With appalling audicity, this is the part that I disagree with. It's not that I think Bernanke's view of the 30s is wrong, I just can't fathom his view of the 20s. I have not read his primary source materials, so the phrase "but what do I know" applies here in profound ways.
"It's not that I think Bernanke's view of the 30s is wrong, I just can't fathom his view of the 20s. I have not read his primary source materials, so the phrase "but what do I know" applies here in profound ways."
It's where the whole field is. If you want to know where it comes from, I guess you could start with Friedman and Schwartz and go forward. The idea that inflation can be "deferred," but eventually has to be dealt with is just considered a fallacious idea.
I actually referred to deferral of deflation rather than inflation. I am not sure inflation can be deferred at all (although it price effects of monetary inflation certainly move unevenly and with a lag.)
Actually, the reason I came back is to note the following from an article about Massachusetts attorneys general suing some banks:
"The Massachusetts civil suit, filed in Superior Court in the state's Suffolk County, alleges that the banks' foreclosure practices were unlawful and deceptive. The suit, which doesn't specify damages, contends the banks—Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co., Citigroup Inc. and Ally—charted a 'destructive path by cutting corners and rushing to foreclose on homeowners without following the rule of law.'"
Wells Fargo caught my eye.
I actalually meant deflation. The idea that either can be post poned for long periods is not widely believed.
I agree with Bob.
Which of the Rep. candidates did not support the bailouts, advocates a gold standard? I can't think of his name...
Huntsman??
Luke:
The name escapes you (us) because it is never mentioned on any national news show. It's kinda like Lord Voldemort (Oops. He who's name is not to be mentioned.)
Dave
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I originally had some pre-conceived notion about what the subject of this conversation was going to be about and had initially decided not to listen to the conversation. Then I just decided that I should with the idea that if it went the way my pre-conceived notion went that I would quit.
My goodness, I was so wrong. Threw my pre-conceived notion out and was really drawn in.
I need to keep that in mind.