Obama's Disappointing Speech: Lessons from Louis Brandeis
President Obama's speech in New York this week was disappointing. As a diagnosis of the problems that led us into financial crisis, it was his clearest and best effort so far. He didn't say it was a rare accident for which no one is to blame; rather he placed the blame squarely on the structure, incentives, and actions of Wall Street.
But then he said our regulatory reforms will fix that. This is hard to believe. And even the president seems to have his doubts because he added a plea that—in the meantime—the financial sector should behave better.
The audience comprised our financial elite, but the Wall Street Journal reports "not one CEO from a top US bank was in attendance." How's that for demonstrating respect, gratitude, and a willingness to behave better?
Louis Brandeis, of course, would have seen things differently. The author of "Other People's Money: and How the Bankers Use It," was under no illusions concerning the underlying financial power structures and how they operated. He would have regarded an appeal to the better nature of bankers as somewhere between humorous and sad.
The only thing that will make a difference is regulation. This is the lesson of the 1930s in the US—the regulations imposed at that time created a financial sector that did not impede growth after World War II; basic intermediation (connecting savers and borrowers) worked fine and destabilizing frenzies were avoided. During this period, the financial sector came up with venture capital, ATMs, and credit cards—arguably the three most important financial innovations of the past 100 years, and much more helpful of real innovation than anything you've seen since 1980.
President Obama claimed that three regulatory proposals will make the system safer.
"First, we're proposing new rules to protect consumers and a new Consumer Financial Protection Agency to enforce those rules." This is a very good thing and, of course the banks are adamantly opposed. But this Agency will not by itself bring us financial stability; that requires change at the level of how banks and other financial institutions are operated.
Second, he talked about "gaps in regulation"; this is international finance bureaucrat code for mush (doesn't the president know this?). The specific potentially interesting pieces he put under this heading were run together in this paragraph:
"While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms, we'll create an oversight council to bring together regulators from across markets to share information, to identify gaps in regulation, and to tackle issues that don't fit neatly into an organizational chart. We'll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That's one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can't take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms."
Making the Fed responsible for the largest firms could work, but only if the Fed throws out pretty much everything about the Greenspan doctrine of cleaning up after financial messes, rather than preventing them. There is no indication they are moving in this direction.
The oversight council is unlikely to make a difference. If you ask someone "Who is responsible for this problem?" and they answer, "Well, we have a committee," does that make you feel better or worse?
The administration will not tell anyone the exact capital and liquidity requirements they are proposing, but close observers of the internal administration process have taken to calling the likely increases "dinky". Remember, the last time our financial system showed this taste for risk and a comparable level of incompetence (prior to 1935), it had equity relative to assets roughly three times current levels (e.g., put into tier one–equivalent terms). There is no proposal on the table, either in the United States or within the G-20, that is even remotely in the right ballpark. President Obama has put his finger on the problem but is apparently unwilling to do anything about it.
The most remarkable phrasing is probably "Even as we've proposed safeguards to make the failure of large and interconnected firms less likely, we've also proposed creating what's called 'resolution authority' in the event that such a failure happens and poses a threat to the stability of the financial system. This is intended to put an end to the idea that some firms are 'too big to fail.'"
It is very hard to understand how the administration can say this with a straight face. Certainly a resolution authority would help, but all bank interventions are negotiated receiverships or conservatorships of some kind. When banks are failing, they need a lot of money fast and you have them over a barrel. But if they are vast, complex, and—remember this—cross-border, then taking them over or shutting them down can be scary, whether or not you have a "legal authority." Please point out to me (1) what the United States is pushing the G-20 to implement in terms of a cross-border resolution authority; and (2) how you would intervene in a bank like Citi without a cross-border authority. This rhetoric around this issue is completely not serious—in fact, it's a distraction from the real issues.
And, of course, the real issues were not mentioned at all.
1) The largest financial institutions have to be made smaller; aim to make them under $100 billion in assets—roughly the size of CIT Group, which even this Treasury was willing to leave to its own devices. We can do it with legislation now or by regulatory fiat next time the behemoths get into trouble, but we should do it before they ruin us.
2) The people who run banks like to talk about "skin in the game" in various contexts, but they generally have only a small proportion of their wealth at risk in these financial institutions. This is not a panacea of course, but it is completely fair to ask them to stake a large part of their fortunes. If they respond that this is not fair because all kinds of things can happen that are beyond their control, you should say, "Agreed—so split your bank up and manage something much smaller."
3) The revolving door between Wall Street and Washington is out of control. There is no way people should be able to go directly (or even overnight) from a failing bank to designing bailout packages to benefit such banks. In any other industry, in any other country, and at any other time in American history, this would have been seen as an unconscionable conflict of interest. Let's get our principles back and impose a five-year moratorium on such flows in either direction.
4) The way the Fed operates means that, in the absence of tough regulation, the finance industry has at its disposal the world's greatest ever bailout machine. Our financial elite know this and are acting accordingly.
Brandeis was scathing about the individuals behind the financial structures. For him, it was about power and it was about control. He was appalled by how big finance operated and he worked hard—an uphill slog—to rein it in.
But Brandeis never saw anything like what we have now experienced, with regard to the amount of taxpayer money that the banks are able to expropriate when downside risks materialize. The big banks that Brandeis feared did not, in the end, dominate the 20th century. But they are back now, with unfettered power and an arrogance that spells trouble.
Ultimately, we will put the banks back in their regulatory box or they will bankrupt us all.
Also posted on Simon Johnson's blog, Baseline Scenario. Following are previous posts this week.
Where Are We Again? (Pre–G-20 Pittsburgh Summit) (September 14, 2009)
This revision to Baseline Scenario is required reading for my Global Entrepreneurship Lab (GLAB) class at MIT this week. For those classes, please also look at these updated slides.
Financial markets have stabilized—people believe that the US and West European governments will not allow big financial institutions to fail. We have effectively nationalized any banking system losses, but we'll let bank executives enjoy the full benefits of the upside. How much shareholders participate remains to be seen; there will be no effective reining in of insider compensation (my version; Joe Nocera's view). Small- and medium-sized banks, however, will continue to fail as problems in commercial real estate continue to mount.
The economic recovery, in the short term, may be surprisingly strong in terms of headline numbers; this is a standard feature of emerging markets after a crisis (e.g., Russia from 1998 or Argentina after 2002). Official short-term forecasts are probably now too low, as the IMF and other organizations make the case for continued fiscal stimulus and very loose monetary policy.
However, a two-track economy appears to be developing: one part will do well (e.g., around big banks on Wall Street), and another part will struggle (many consumers and firms around the world want to reduce their debt; the same thing happened in Japan's "lost decade"). During the 1990s, Japan had some years with good growth, but overall the decade was a disappointing deceleration of growth; the same could be true now at the global level.
Longer term US growth prospects remain particularly uncertain—has consumer behavior really changed; if finance doesn't drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)? The implication, presumably, is higher taxes on the productive nonfinancial part of the economy—to pay for the implicit subsidies and ongoing rents of the financial sector. While many entrepreneurs understand and resent this math, they are strikingly unwilling to do anything about—or even speak out on—reining in the power of the biggest banks. Even the smaller banks—who have really been hammered by the actions of larger banks—are only just now figuring this out and beginning to express resentment; sadly, it is too late to make much difference.
There has been a great deal of attention recently on income distribution (Wall Street Journal; New York Times), with the argument being that the long financial boom made some people richer and the bust is bringing them back down. But this misses the point that (1) some of the mega-rich will do very well—think about how Carlos Slim took over large parts of the Mexican economy after 1995, and watch Wilbur Ross acquiring assets in the United States today; (2) billionaires becoming millionaires is hardly something to get worked up about.
The real damage is for 10 to 15 percent of American society, mostly without college education, who lost jobs, houses, and education opportunities. The First Great Depression was a decade of effective poverty and other terrible outcomes for around 25 to 30 percent of American society. We have avoided a Second Great Depression but the social costs are still huge. Think through the political implications of that.
The collapse of Lehman Brothers and the ensuing financial crisis in particular exposed serious weaknesses in our banks, insurance companies, and financial structures more generally. We were "saved" by radical central bank action and additional government spending. Over the past 20 years, crises have become more severe and more expensive to counteract. We are on a dangerous and slippery slope.
Yet there is no real reform underway or on the table on any issue central to (1) how the banking system operates; or (2) more broadly, how hubris in finance led us into this crisis. The financial sector lobbies appear stronger than ever. The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it's hard to see them making much progress on anything—with the possible exception of healthcare (and even there, the final achievement looks likely to be limited).
The latest New York Times assessment of financial sector reforms is bleak. The Washington Post is running an excellent series on exactly how and why the banks have become stronger (part one; part two). Big banks have risen greatly in power over the past 20 years and were already strong enough this winter to ensure there was no serious attempt to rein them in.
Financial innovation is under intense pressure in both popular and technocratic discussions, but does not face any effective regulatory controls (our view; Adair Turner). This is a dangerous combination. Unless and until there is real re-regulation of finance, repeated major crises seem hard to avoid. Wall Street responds, "we have changed how we behave," but this must at best be cyclical—after any emerging market crisis, the survivors are careful for a while. But then they go on another spree and you re-run the same boom-bubble-bust-bailout sequence in a slightly different form and with potentially more devastating consequences. The potential for serious crisis will not decline unless and until you change incentives—and this frequently requires a change in power structure (think Korean chaebol, Thai banks, or Indonesia under Suharto).
The consensus from conventional macroeconomics is that there can't be significant inflation with unemployment so high, and the Fed will not tighten before mid-2010. The financial markets are not so convinced—presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide. In all recent showdowns with standard macro models recently, the markets' view of reality has prevailed. My advice: pay close attention to oil prices. The conventional oil market view is that there is plenty of spare capacity so we cannot experience the price spike of early 2008; we'll see if this proves complacent.
Emerging markets, in particular in Asia, are increasingly viewed as having "decoupled" from the US/European malaise. Increasingly, we hear that Asia's fundamentals allow strong growth irrespective of what is happening in the rest of the world. This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new round of financial speculation based in part on a "carry trade" that now runs out of the United States. Most Asian currencies are a one-way bet against the US dollar over the medium-term, as they are already considerably undervalued and their central banks actively intervene to prevent significant appreciation. The appetite for this kind of risk among investors is up sharply.
What should we expect from the Pittsburgh summit on September 24-25? "Nothing much" seems the most likely outcome. The leadership of industrial countries does not want to take on the big banks, and the technocrats have contented themselves with very minor adjustments to key regulations ("dinky" is the term being used in some well-informed circles.) The G-7/G-8/G-20 is back to being irrelevant or, worse, mere cheerleaders for the financial sector. (See Economic Donkeys below.)
Overall, the global economy begins to recover, but the crisis created huge lasting costs for many poorer people in the United States and around the world. Recovery without financial sector reform and reregulation sows the seeds for the next crisis. The precise timing of crises is always uncertain but the broad contours are clear—just like many emerging markets over past decades, the United States, Europe, and the world economy look set to repeat the boom-bailout cycle. This will go on until at least until one or more major countries goes completely bankrupt, or until a real financial reform movement takes hold either among technocrats or more broadly politically—and the consensus then shifts back towards the kind of much tighter financial regulation that was established after the last major global fiasco in the 1930s.
By Peter Boone and Simon Johnson (September 13, 2009)
Early in the First World War, British generals decided to attack German trenches with an initial light bombardment, followed by infantry walking in close order across No Man's Land. The result was tens of thousands killed in a series of military disasters, but the generals reacted with only small adjustments to their approach and essentially persisted in repeating the same mistakes for years. "The English soldiers fight like lions," one German general remarked. "True. But don't we know that they are lions led by donkeys?" was the reply.
Today, a year after global financial collapse and the ensuing tragedy for millions, our economic leaders are lining us up to suffer again (and again) through the same horrible experiences.
The collapse of Lehman Brothers in September 2008 demonstrated just how far our economic system in general and bank management in particular have gone awry. Lehman borrowed at low interest rates in global credit markets, and invested over half a trillion dollars of other people's money in assets which, today, are worth next-to-nothing: failed ski hills in Montana, now empty suburban housing in California, and crazy bets on derivatives (options to buy or sell securities, in various complex combinations).
Worries about these failed investments sparked a run on the bank. And, after a mad weekend of trying to save Lehman, the US "authorities"—meaning Henry Paulson (Secretary of the Treasury), Ben Bernanke (chairman of the Federal Reserve Board), and Timothy Geithner (President of the New York Fed)—decided to let it go bankrupt. Creditors, realizing no major bank is safe if our leaders might now let them fail, pulled cash from major financial institutions and bought relatively safe US Treasuries and UK Gilts.
Today Lehman's senior debt trades at a mere 10 cents on the dollar, suggesting its $600 billion in assets were a mirage. This outcome is even more startling when compared to senior debt at Kazakhstan's defaulting large banks, where management is now accused of serious malfeasance, yet that debt trades at 20 cents on the dollar—twice the price of Lehman's debt.
At the G-20 meeting of finance ministers last week, political leaders united behind two key steps that they claim will "prevent another Lehman": tighter controls on the pay of executives and more capital for banks. France and Germany blame the crisis on lax regulation in Anglo-Saxon markets and excessive pay packets that encourage irresponsible risk taking. The British and Americans counter that European banks have too much debt (i.e., in the jargon, are "overly leveraged"), and need to raise more capital. The final communiqué proposes to do both, and we will hear more of the same at the upcoming G-20 heads of government summit in Pittsburgh. But, in reality, both sides want only minor adjustments that cannot solve the real problems posed by our financial system.
Tim Geithner, now US Treasury Secretary, is pushing for higher capital requirements for banks, i.e., they need to have more shareholder funds to protect against future losses. But he surely knows that two weeks prior to its bankruptcy, Lehman's management reported they were well-capitalized, with a tier one capital ratio of 11 percent—roughly twice what the United States currently considers is needed for a well-capitalized bank, and much higher than the American side is proposing in private conversations.
Christine Lagarde, France's Finance Minister, and Angela Merkel, Chancellor of Germany, helped convince the G-20 that bank compensation policies need to be amended to encourage long-term incentives. They want compensation packages to be limited and bonuses to be locked up, so we can be sure employees' incentives are consistent with the long-term survival of their banks.
Chancellor Merkel and Minister Lagarde need to look no further than Lehman for a model of how to introduce a good policy to align incentives. The top management and many employees in the company were largely compensated in shares of the company, which vested over many years, so when Lehman Brothers went down, it brought crashing down the lives and finances of its 20,000 employees. Dick Fuld, the highly compensated head of Lehman, lost many million dollars—and presumably a large part of his total wealth. Apart from criminal penalties (of the kind not seen for banking in a century), can we think of a better way of aligning incentives with the outcomes for a bank?
The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse. In 1998, a much smaller Lehman Brothers was placed in financial peril by the aftermath of the Asian financial crisis and failure of Long-Term Capital Management, a major hedge fund. The Federal Reserve responded by lowering interest rates and other central banks followed suit. This reduced the cost of obtaining funds, effectively bailing out Lehman and other institutions in trouble.
As markets have grown to recognize how quick the Federal Reserve is to bail out institutions (and executives) in trouble, they naturally respond. In the 1990s, people talked about the "Greenspan Put" a term that derisively suggests that it is always safe to invest in risky assets because the Federal Reserve is ready to bail out investors (a put is effectively a promise to buy an asset at a fixed price if you are unable to sell it to someone else at a higher price—this is a way to lock in profits or limit losses on investments). However, in months following the collapse of Lehman, we learned that the "Bernanke Put" is even more valuable since Chairman Bernanke, alongside the Bank of England, the European Central Bank, and central banks in much of the rest of the world are prepared to take drastic measures to prevent asset prices from falling when there are risks of global collapse.
This policy of responding to the aftermath of bubbles, rather than addressing them before they get going through tighter regulation, has become the mantra of most central banks. It is usually combined with fiscal policy stimulus and other measures to support the economy. Each time banks fail, by bailing the system out again, we teach our finance sector a lesson: you can safely take too much risk because when you lose, the taxpayer will pick up the bill. We also send a simple message to creditors: it is safe to lend to Goldman Sachs or Barclays Bank because taxpayers and our nations' savers are standing by to cover your losses. Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits. Such a system is destined to fail, but the party can run for a long time.
While Ben Bernanke has done a wonderful job of preventing financial meltdown, his calls in 2002–2003 for very low interest rates, without fixing our financial system, contributed to the credit expansion that led us into the current mess. In the United Kingdom, the Conservatives plan to transfer regulatory powers to the Bank of England, despite the fact that, like the Federal Reserve, the Bank of England has been a key component of our ever growing cycles of credit expansion and bust.
The "collapse or rescue" decision forced by Lehman's failure is a symptom of a much larger systemic problem. We need leaders, both in the financial world and in public service, who recognize that our financial sector too often causes social harm. There is no doubt that it also provides valuable services that are vital to the well-being of our pensioners and savers and helps manage and mitigate risk for our corporations. Yet too often these activities cause losses, which—either directly or indirectly—become a burden on the rest of society.
The pre-crisis activities and portfolios of Barclays, Goldman Sachs, and other "survivors" of this crisis were only slightly different from Lehman Brothers or Bear Stearns, which failed. The "good" banks also securitized subprime assets, helped build the intricate web of IOUs between banks and insurance companies, and leveraged their balance sheets to enormous levels. The winners were not better, they were just smart enough to make sure someone else held the bad assets when the music stopped, and they were powerful enough to win generous bailout packages from their governments.
The danger we face is that by bailing out these institutions and rewarding failed managers with new powerful positions, we have now created a much more dangerous financial system. The politically well-connected, knowing they will most likely do fine in the next crisis, are now highly incentivized to take even greater risk.
Once we admit this profound problem in our system, we can begin to think of the radical measures needed to solve it. There is no doubt these solutions will include much greater capital requirements, so that bank shareholders know that they face substantial losses if their ventures fail.
But, we also need to ensure that our regulators are not captured by the banks that they are meant to oversee. This means we need to put checks on financial donations to political parties, and we need to buttress our regulators with more intellectual firepower and financial resources, along with rules that ensure independence, in order to be sure they can act in the interests of the broader population.
We also need to close the revolving door through which politicians and regulators leave office to earn their nest eggs in finance and "financial experts" move directly from failing banks to designing bailout packages. The conflicts of interest are abundant and most dangerous.
Last week the United Kingdom's chief financial regulator, Adair Turner, faced heavy criticism from the City, Chancellor Darling, Boris Johnson, and editorials in the Financial Times and Wall Street Journal. His main offense was daring to raise the issue of whether parts of our financial system have become socially dysfunctional in an interview with Prospect Magazine. He called for greater capital requirements at banks, and he pondered how it would be possible for regulators to preserve the valuable parts of our financial system while ensuring that regulation limited the harmful parts. These are eminently sensible questions that anyone with a public spirit should understand are critical policy issues today.
Sadly, these public rebukes to Lord Turner are a further indication that very few of our leaders are prepared to even discuss the real problem, let alone seek a sufficient solution. Smart people and well-organized governments can, as in the past, behave like donkeys.