Diana Farrell and the White House Theory of Bank Size
On Friday morning (October 9), Diana Farrell—a senior White House official—made a significant statement on NPR's Morning Edition with regard to whether our largest banks are too big and should be broken up.
"Ms. Diana Farrell (Deputy Assistant for Economy Policy): We understand Simon Johnson's views on this, and I guess the response is the following….
"Ms. Farrell: We have created them [our biggest banks], and we're sort of past that point, and I think that in some sense, the genie's out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we're unlikely to ever come back to or want to come back to." (full transcript)
Ms. Farrell is Larry Summers's deputy on the National Economic Council and the former director of McKinsey Global Institute, and she has a strong background on banking issues—based on extensive professional experience with global financial institutions.
Her statement contains three remarkable points.
First, "we have created them" is exactly right. Today's mega-banks were not created by any market process. They are the result of a series of government actions and inactions, particularly over the past 18 months. Banks failed due to their own mismanagement but how those failures were handled—bankruptcy vs. bailout—was a conscious official decision. This administration deliberately chose to be very nice to the biggest banks and to the people who run them.
Second, "we need to… manage them and oversee them." Here she is presumably referring to the administration's regulatory reform plan, which does not appear to be going well. Once the massive banks were created, and implicitly backed by the government, it became (already by April or May of this year) very hard to reregulate them. As Joe Nocera pointed out on Saturday, the biggest banks have essentially bitten the Obama administration hand that fed them—most obviously by opposing the new Consumer Financial Protection Agency. It is already abundantly clear that the White House cannot control our big banks. What hope do mere regulators have?
Third, "we're unlikely to ever … want to come back to…." Ms. Farrell's specifics on this point were summarized by the interviewer, Alex Blumberg, "The problem with Johnson's approach, [the administration] decided, is that bigness also has its benefits. Sure, the economy used to be simpler and financial institutions weren't so big and dangerous, but GDP was smaller then, too, and people were poorer."
I haven't found even an assertion that our largest banks should get bigger, in absolute size or relative to the economy, let alone any facts or relevant empirical evidence. If I have missed a convincing quantification for "bigness also has its benefits," please draw that to my attention.
Perhaps there is a reason that today's nonfinancial companies need a financial sector that is more concentrated and more powerful politically than ever seen in living memory—maybe this emerges from the Financial Services Roundtable or the government's more confidential interactions with CEOs. But my conversations with people who run companies or who work closely with nonfinancial executives suggest quite the opposite—they see our current financial system as dangerous, with the likely costs of big banks (e.g., future bailouts) greatly outweighing any benefits.
Here's the end of the NPR segment, where Alex Blumberg gives a fair summary:
"Blumberg: In the end, what we should do about the genie comes down to how you think about it. Farrell's view and the view of economists like Calomiris from Columbia University is that the genie does lots of good things for us and that we can learn to restrain it.
For Johnson, the good things that the genie does are outweighed by the bad things and we should be thinking hard about how to get it back in that bottle before it wreaks havoc once again."
If Ms. Farrell and the White House (or anyone else) has hard numbers we can put on the benefits of big banks, please make these public. We can then weigh these against the obvious costs of running our financial system in this fashion—on this round alone: fast approaching 40 percent of GDP, i.e., the increase in government debt as a direct result of our financial fiasco; plus persistently high unemployment; millions of homes lost; likely permanent loss of output, etc.
Philipp Hildebrand, now head of the Swiss National Bank (SNB), expressed a more moderate official position in June, "A size restriction would of course be a major intervention in an institution's corporate strategy… Naturally the SNB is aware that there are advantages to size. [But] in the case of the large international banks, the empirical evidence would seem to suggest that these institutions have long exceeded the size needed to make full use of these advantages."
Also posted on Simon Johnson's blog, Baseline Scenario. Following were previously posted:
Too Politically Connected to Fail in Any Crisis
October 8, 2009
Over the past 30 years Wall Street captured the thinking of official Washington, persuading policymakers on both sides of the aisle not to regulate (derivatives), to deregulate (Gramm-Leach-Bliley), not to enforce existing safety and soundness regulations (VaR), and to stand idly by while millions of consumers were misled into life-ruining financial decisions (Alan Greenspan).
This was pervasive cultural capture or, to be blunter, mind control. But when the crisis broke it was not enough. Having powerful people generally on your side is not what you need when all hell breaks loose in financial markets. Official decisions will be made fast, under great pressure, and by a small group of people standing up in the Oval Office.
If you run a big troubled bank, you need a man on the inside—someone who will take your calls late at night and rely on you for on the ground knowledge. Preferably, this person should have little first-hand experience of the markets (it was hard to deceive JP Morgan and Benjamin Strong when they were deciding whom to save in 1907) and only a limited range of other contacts who could dispute your account of what is really needed.
Goldman Sachs, JPMorgan, and Citigroup, we learn today, have such a person: Tim Geithner, secretary of the Treasury.
We already knew, from the NYT, that most of Geithner's contacts during 2007 and 2008 were with a limited subset of the financial sector—primarily the big Wall Street players who were close to the New York Fed (including on its board). And the announcement of his appointment was widely regarded as very good news for those specific firms.
But Geithner himself has always insisted that his policies are intended to help the entire financial system and thus the whole economy.
"Secretary Timothy Geithner: I've been in public service all my life. I've spent all my life working in government on ways to make our financial system stronger, better economic policy for this country. That's the only thing I've ever done. And I would never do anything and be part of any policy that's designed to benefit some piece of our financial system. The only thing that we care about and the only obligation I have is try to make sure this financial system is doing a better job of meeting the needs of businesses and families across the country." Interview on Lehrer NewsHour, May 8, 2009
Geithner's defenders insist that his specific contacts while president of the NY Fed were a function of that position; "he was only doing his job."
But today's AP report, based on looking at Geithner's phone records from the inauguration through July, suggests something else. How can anyone build an accurate picture of conditions in the entire crisis-ridden financial sector primarily from talking to a few top bankers?
The list of phone calls is not the largest banks, because some of the biggest are hardly represented (e.g., Wells Fargo); it's not the most troubled banks (e.g., Bank of America had little contact); and it's not even investment banker-types who were central to the most stressed markets (Morgan Stanley was not in the inner loop). And small- and medium-sized banks (and others) always bristle at the suggestion that their interests are in alignment with those of, say, Goldman Sachs.
Geithner's phone calls were primarily to and from people he knew well already—who had cultivated a relationship with him over the years, shared nonprofit board memberships, and participated in the same social activities. These are close professional colleagues and in some cases, presumably, friends.
The Obama administration had to rescue large parts of the financial sector, given the situation they inherited. But it absolutely did not have to run the rescue in this exact fashion—bending over backwards to be nice to leading bankers and allowing their banks to become even larger. Saving top executives' jobs under such circumstances is not best practice, it's not what the United States advises to other countries, it's not what the United States tells the IMF to implement when it helps clean up failed banking systems, and it's not what the FDIC implements for failed banks under its auspices.
The idea that you could leave big US bank bosses in place (or let them get stronger politically) and do meaningful regulatory reform later has always seemed illusory—and this strategy now appears to be in serious trouble. But presumably Mr. Geithner's financial advisers told him this was the right thing to do.
October 7, 2009, with James Kwak
We've been at first amused but more recently alarmed at how "global imbalances" are becoming many people's preferred explanation of the financial crisis. At first you could brush it off this way: "global imbalances (read: ‘blame China')…" But this explanation is going mainstream, not least because it is always more convenient for policymakers and bad actors to blame someone far away. For example, Dealbook (New York Times) kicked off a roundtable on the causes of the financial crisis this way:
"There is a conventional view developing on the financial crisis. The Federal Reserve's policy of historically low interest rates spurred a worldwide search for higher risk and return. Concurrently, the entrenched United States trade imbalance led to a huge transfer of dollar wealth to Asian and commodity-based countries. The unwillingness of Asian economies, particularly China, to stimulate their own domestic consumption led these countries to reinvest the proceeds into the United States. This further contributed to lower American interest rates and further fueled the search for return."
(Mortgage securitization gets mentioned, but only in the fourth paragraph!)
Simon and I took this on in our Washington Post online column this week, but I thought it was interesting enough to repost here in full, below.
The time is here for our nation to actually do something about the recent financial crisis—that is, do something to prevent it from happening again. But instead, many people are finding it easier to pass the buck than to, say, regulate the financial sector effectively.
According to this story, the global financial crisis was caused by hardworking Chinese factory workers who committed the sin of over-saving, which created a glut of money that needed to be invested, conceptualized in a great episode of public radio's "This American Life" as the "giant pool of money." (Japan and the oil exporters also had large surpluses, but for political reasons, the finger generally gets pointed at China.)
This beast from the East, seeking higher yields than it could find in Treasury bonds, flooded into the housing market, pushing down interest rates and pushing up housing prices, and creating a bubble that finally collapsed, with the results we all know. (More nuanced proponents of this theory hold, in a "fair and balanced" sort of way, that over-savers in China and under-savers in the United States—and other countries, like Spain, Britain, and Ireland—are equally to blame; in any case, it's the imbalance that's the problem.) This is a convenient story because it absolves us of any need to put our own house in order through better regulation.
Like most errors, this story contains an element of truth. In general, it is not a good thing for a country to consume more than it produces indefinitely because to pay for its excess consumption it must borrow money from the rest of the world, and that country can consume more than it produces only if some other country produces more than it consumes. In particular, the US-China imbalance is due in part to the Chinese policy of keeping its the value of its currency artificially low—encouraging Americans (and other foreigners) to buy Chinese exports and discouraging its citizens from buying imported goods.
But the "blame China" story (or the "half-blame China" variant) suffers from serious problems. First, it takes two to tango. No one put a gun to the American consumer's head and forced him to buy a new flat-screen TV or to do so by taking out more debt. (Nor are the Chinese somehow morally superior to us; one reason why they save so much more than Americans is that, with no social safety net to speak of, they have to.)
Second, the Chinese government did not lend to American home buyers directly. China bought US Treasury and agency (Fannie Mae, Freddie Mac, etc.) bonds, which put more money into housing and also crowded other people's money into housing. But the vast majority of Chinese money went into the safer bits of the US financial system; the speculative money came largely from European banks. And all the actual lending decisions were made by financial intermediaries (banks, mortgage lenders, etc.), which made plenty of bad decisions along the way while regulators, from Alan Greenspan on down, looked the other way.
Third, there is no particular reason why a "giant pool of money" should produce a bubble. A savings glut should lower interest rates, which should increase the value of housing; a bubble occurs when prices go up more than dictated by fundamentals like interest rates. If the run-up in housing prices was a direct result of over-saving in China, then housing prices should have fallen only if China stopped over-saving—which has not happened.
While Chinese over-saving was a contributing factor to the recent crisis, it was neither necessary nor sufficient. Cheap money is not bad in and of itself—all other things being equal, it's better to have people lending to you at low rates than at high rates. The problem is what we did with the cheap money.
For the long-term health of the economy, we want that money to flow into capital investment by the business sector because that is the best thing we know of to boost long-term productivity growth. Instead, though, Tim Duy has a great chart, showing that the rate of growth of investment in equipment and software in the 2000s was far below the rate in the 1990s, even with all the cheap money of this decade.
This may seem like an obscure point, but basically it means that even with the low rates of the Greenspan Fed, and even with all that cheap money from overseas, we couldn't get it where we needed it to go because it was being sucked up by the housing sector. And it was being sucked up by the housing sector because lenders earned fees for making loans that could not be paid back, and banks earned fees for packaging those loans into securities, and credit rating agencies earned fees for stamping "AAA" on those securities, and all sorts of financial institutions—including those same banks—loaded up on these securities because they offered high yield and low capital requirements. In short, we had a dysfunctional financial system that failed at its most fundamental job—allocating capital to where it benefits the economy the most.
Encouraging productive investment by businesses and preventing the next bubble go hand in hand—both require fixing the financial system. Blaming global imbalances—a consequence bereft of either a subject (an actor) or a verb (an action)—is only a way of avoiding our real problems.