Meyerson: Simon Johnson is Right

Harold Meyerson certainly seems to agree with Simon Johnson's argument that the financial sector has become both too large economically and too powerful politically. In his last column, Meyerson essentially paraphrases Johnson's recommendations for dealing with this crisis. From the Washington Post:

The Democrat in the White House and the Democrats on the Hill are committed to legislation that regulates our dysfunctional wards in the banking industry, but regulations by themselves won't solve the problem of the banks being too big to fail -- and so big that they dominate campaign finance and, with it, much of the business of lawmaking. We need to amend our antitrust laws so we can scale down banks to the point that they no longer imperil our economic and political systems. As things stand now, it's we who are serving their needs, not they who are serving ours. It's time to turn that around.

While many in the media have been quick to dismiss Johnson as a radical, it is certainly encouraging to see his ideas gain some currency among more mainstream voices. Because if we do not build a consensus about checking the outsized influence of Wall Street, we will only set ourselves up for an even bigger crisis in the future, assuming we make it through this one over the next year or two.

And Now You Find Yourself In '82?

As Simon Johnson notes, the administration seems to be following a different script for dealing with the banks from the liquidation/receivership/subsidization troika Elizabeth Warren outlined in her last TARP oversight report. This fourth option - what Simon Johnson calls "forebearance" - is essentially hoping banks can earn their way out of insolvency. By relaxing accounting rules on mark-to-market and providing just enough capital to keep banks operating, the administration hopes that a rebounding economy along with cheap money will provide enough earnings opportunities for banks to work their way back to health. Johnson points out that this is more or less the approach Volcker took with the banks after the 1982 Latin American debt crisis likely pushed many into de facto insolvency. But Johnson sees three factors that make such a policy succeeding today unlikely:

• this is a global slump
• the real economy will probably keep deteriorating, unlike the 1982 recession when there was a sharp turnaround after the Fed lowered rates
• there are more speculative attacks on banks today

Hedged Bet argued that forebearance was the real Geithner plan after Warren Buffet hinted as much on CNBC last month. It seemed like a plan to emulate Japan's zombie banks then, and it still does now. Let's hope this really isn't the plan.

Establishment Media: We Hope Liberal Critics Are Wrong (Though We Doubt It)

Liberal critics of the Paulson/Geithner bailouts have levied three main criticisms to date: first, subsidies to banks represent highly costly transfers of wealth from taxpayers to bankers; second, insolvent banks need to be put into receivership, rather than subsidized; and third, policymakers have avoided restructuring banks because of they are still enthralled in the ideology of market worship/the banking lobby has captured the government. Paul Krugman and Joseph Stiglitz have popularized the first two points, while former IMF chief economist Simon Johnson provocatively advanced the third point in his recent piece in the Atantic.

What has been the response from the administration and the establishment media to these fairly devastating critiques? Government officials have suggested those calling for temporary nationalization are either naive or simply wrong; leading media voices, meanwhile, have expressed unease - unease because they hope these liberal critics are wrong, but they're not confident of it. From Newsweek:

If you are of the establishment persuasion (and I am), reading Krugman makes you uneasy. You hope he's wrong, and you sense he's being a little harsh (especially about Geithner), but you have a creeping feeling that he knows something that others cannot, or will not, see. By definition, establishments believe in propping up the existing order. Members of the ruling class have a vested interest in keeping things pretty much the way they are. Safeguarding the status quo, protecting traditional institutions, can be healthy and useful, stabilizing and reassuring. But sometimes, beneath the pleasant murmur and tinkle of cocktails, the old guard cannot hear the sound of ice cracking. The in crowd of any age can be deceived by self-confidence, as Liaquat Ahamed has shown in "Lords of Finance," his new book about the folly of central bankers before the Great Depression, and David Halberstam revealed in his Vietnam War classic, "The Best and the Brightest." Krugman may be exaggerating the decay of the financial system or the devotion of Obama's team to preserving it. But what if he's right, or part right? What if President Obama is squandering his only chance to step in and nationalize—well, maybe not nationalize, that loaded word—but restructure the banks before they collapse altogether?

And this from a New Republic piece on Simon Johnson:

there's something that bothers me ever-so-slightly about the piece. It turns up as Johnson shifts from the political economy of an emerging-market financial crisis to the political economy of American finance over the last 25 years to the political economy of this particular crisis....

In the United States, Johnson argues, the situation is even more insidious in some ways. Our own financial elites have not only been politically ascendant for the last generation, but intellectually ascendant, too. Policymakers blithely adopted the view that vast unregulated flows of capital were in the national interest--a view that just happened to overlap with Wall Street's self-interest. "A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true," Simon writes. A bit hyperbolic, I'd say, but definitely a kernel of truth here.

It's the last pivot where Johnson loses me. Well, he doesn't exactly lose me, because I worry he may be right. But he certainly leaves me a little cold. Johnson concludes that American financial elites "are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive." He adds that we're afflicted by "a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support." Johnson's preferred solution--one I'm sympathetic to--is that the government seize weak banks, recapitalize them, and sell them off in pieces. But he thinks this is next-to-impossible so long as Wall Street stays so powerful.

Now, certainly there are a lot of data points consistent with the financial sector having a veto over public policy. As Johnson notes, a lot of the bailouts the Fed and Treasury have arranged left the banks basically intact. By most reasonable measures, the terms have been more favorable to bankers than to taxpayers, which raises questions about who controls whom. Likewise, the Geithner plan certainly goes to elaborate lengths to avoid seizing banks, which also looks on its face like the work of an overly-solicitous policy mind.

On the other hand ... we just don't know. Johnson has performed a service by marshalling the available data points and drawing some provocative connections, but he's not great at establishing what's driving what....

The point is that figuring out whether financial interests control public policy is a question that needs to be answered directly--with documents and testimony. You can't just infer it from a bunch of circumstantial evidence.

This unease comes from fear that populists may be right. For our elites, populism is a knee-jerk reaction on the part of the uneducated, unsophisticated masses. It is almost always wrong. But today, as Simon Johnson points out below, some of the most respected members of the economics profession - along with members of the educated classes spanning the political spectrum - could easily be mistaken for full-blown populists.

This creates cognitive dissonance within establishment circles, especially traditional left-of-center publications that place great weight in the opinions of experts such as Krugman, Stiglitz and Johnson. They would seem to have only two choices: either claim that such denunciations are wrongheaded, or admit that the critics are right. Instead, they have hedged their bets, explaining that the critics make compelling cases, but perhaps they go too far; these critics can't prove what they're saying in a court of law, after all. This is nothing more than a craven refusal to perform their roles as journalists. Instead of investigating the claims of critics, they try to assuage the public's anger at the bailouts with flimsy defenses of the establishment, while acknowledging that something might be rotten in the District of Columbia. Their ostensible role as public watchdogs demands that they do more than simply cross their fingers that we don't live in a banana republic.

Boring is the New Sexy In Banking

It's back to the future in the banking world - that is, if our policymakers are serious about reforming our financial system. The myth that financial "innovation" cannot be stifled, lest the economy stagnate, has now been laid to rest. Financial "innovation" merely allowed bankers to take and spread risks they did not understand, perform regulatory arbitrage, and justify their exorbitant salaries. Paul Krugman and Simon Johnson both make the case that we should end the era of free-for-all casino capitalism, and move back to the type of more stable, boring banking system we had during the postwar period up till 1980. From Krugman:

Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some of which later turned out to have been based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative for those who ran it. Banking became boring, partly because bankers were so conservative about lending: Household debt, which had fallen sharply as a percentage of G.D.P. during the Depression and World War II, stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits.

As these changes took place, finance again became a high-paying career — spectacularly high-paying for those who built new financial empires. Indeed, soaring incomes in finance played a large role in creating America’s second Gilded Age....

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

Simon Johnson strikes a similar note, calling on policymakers to

make banks smaller, less powerful, and much more boring.

Using antitrust laws to break up too-big-to-fail banks into smaller parts, and re-instituting Glass Steagall and the division between commercial banking, which exists as a public utility, and investment banking, which takes on riskier enterprises underwriting securities, would be a good start. Unfortunately, Geithner and Summers seem too enamored with Wall Street to enact these reforms. We can only hope that more politicians can muster the common sense and historical humility that Senator Byron Dorgan did a decade ago, in condemning the repeal of Glass Steagall and deregulatory mania in general as an inevitable step towards a new crash.

Shanty Towns

As foreclosures continue to devastate communities, and unemployment mounts, it seems like more stories like this one from the Today show about the rise of shanty towns - or Bushvilles - in Sacramento, Seattle, Reno, and Nashville will become more commonplace.

Any governor who has threatened to reject any stimulus money, particularly extended unemployment benefits, should be forced to go visit these encampments.

Now what can we do to prevent these settlements from exploding in size? Creating jobs is the obvious first step. Hopefully, the stimulus and the benefits aimed at the most at risk within society will help. But we also need debt reduction for insolvent households, primarily by writing down the face value of mortgages to reflect current prices. With so many borrowers underwater on their mortgage - and many more likely to find themselves there over the next few years, as housing prices most likely still have 20-30% to fall - there will be a terrible incentive to do jingle mail, and simply walk away. This will cause housing prices to overshoot on the downside. Reducing mortgage debt will not only mitigate foreclosures, but boost aggregate demand. Nouriel Roubini has long called for a reincarnation of the HOLC of the Great Depression to buy up mortgages, in order to refinance/renegotiate the terms. Roubini elaborated on this point on CNBC yesterday.

Why can't we find a job in the Treasury department for Roubini? And Krugman, Stiglitz, Shiller, and Simon Johnson as well, for that matter?

The Banking Lobby

The banking lobby is digging in to make sure that we learn nothing from this crisis, so they can keep playing their heads-we-win-tails-you-lose game. From Bloomberg:

Alan “Ace” Greenberg, the former Bear Stearns Cos. chief executive officer, said he sees a “very small” chance the Great Depression-era Glass-Steagall Act that separated banking and investment banking could be reinstated.

“Practically you can forget about it, it’s not going to happen,” Greenberg, 81, said today in an interview on Bloomberg Television. “The people who lobbied so extensively for the extinction of Glass-Steagall are still around.”

This is why Simon Johnson talks about the only obstacle to effectively fixing our financial system, since most economists agree temporary nationalization is the best option, is the power of the banking lobby. They really do control the levers of government. If the seemingly endless stream of cash Wall Street has siphoned off from the taxpayers isn't going to be a total waste, we need to put preventive measures in place to guarantee this type of crisis never happens again (at least in our lifetimes, until our children and grandchildren forget our lessons, as we did with the lessons of the Greatest Generation).