Most days we can coast along, confident that tomorrow will be much like yesterday. On a very few days we need to look hard at the news headlines, click through to read the whole story, and then completely change a large chunk of how we thought the world worked. April 28 was such a day.
Everything you knew or thought you believed about the European economy—and the eurozone, which lies at its heart—was just ripped up by financial markets and thrown out of the proverbial window.
While you slept, there was a fundamental repricing of risk in financial markets around Europe—we’ll see shortly about the rest of the world. You may see this called a “panic” and the term conveys the emotions involved, but do not be misled—this is not a flash in a pan; financial markets have taken a long hard view at the fiscal and banking realities in Europe. They have also looked long and hard into the eyes—and, they think, the souls—of politicians and policymakers, including in Washington last weekend.
The conclusion: Large parts of Europe are no longer “investment grade”—they are more like “emerging markets,” meaning higher yield, more risky, and in the descriptive if overly evocative term: “junk.”
This is not now about Greece (with 2-year yields reported around 20 percent) or Portugal (up 7 basis points) or even Spain (2-year yields up 27 basis points; wake up please) or even Italy (up 6 basis points). This is no longer about an IMF package for Greece or even ring-fencing other weaker eurozone economies.
This is about the fundamental structure of the eurozone, about the ability and willingness of the international community to restructure government debt in an orderly manner, about the need for currency depreciation within (or across) the eurozone. It is presumably also about shared fiscal authority within the eurozone—i.e., who will support whom and on what basis?
It is also, crucially, about stabilizing the macroeconomic situation without resorting to more unconditional bailouts. Bankers are pounding tables all across Europe, demanding that governments buy out their position—or bring in the IMF to do the same. We again find ourselves approaching the point when the financial sector will scream: Rescue us all or face global economic collapse.
The White House did not see this coming—and the Treasury’s attention was elsewhere. The idea that we can leave this to the Europeans to sort out is an idea of yesterday. Today is very different and much scarier.
President Obama is wide awake and working hard. Someone please tell him what is really going on.
Also posted on Simon Johnson’s blog, Baseline Scenario. The following were previously posted.
Three Modest Proposals for Goldman Sachs (April 27)
At this stage in the proceedings, the Goldman Sachs’ public relations people must be feeling more than a little down. The firm’s lawyers are still breathing fire, Lloyd Blankfein trod the fine line between not being apologetic and actually saying “it’s capitalism, stupid,” and the more junior executives interrogated on Tuesday did not say anything blatantly incriminating. But the public image of the firm around the world—including with finance ministers and pension funds—has taken a severe beating.
In the interests of finding a more positive and cooperative way forward, here are three suggestions for the PR team to take up with senior management—once they are in the mood to think long-term about their “franchise value” again.
- Come out in support of some form of financial reform. The really clever move would be to support something that is not likely to pass, such as size restriction on the biggest banks—keeping in mind that this would hinder JP Morgan Chase and Citigroup much more than Goldman (which was a much safer size not so long ago). Almost as smart would be to endorse the consumer protection agency for financial products—given that Goldman does not deal with many retail investors. In any case, surprise us with support for something that the administration in general or Mr. Volcker in particular is proposing.
- Create a corporate pledge not to use “astro turf”/fake grassroots organizations to spread disinformation, then invite other leading firms to sign on. The current leading fraud in this area is incredibly embarrassing for the financial sector, in the language of Jamie Dimon. It self-demonizes the entire industry. Why would you, Goldman Sachs, want this? This is not a good trade and it is getting worse; the traditional deniability claims will not help against the coming backlash. Close the position—and make sure you get maximum public relations points for doing so.
- Settle the SEC case as soon as possible. Pay whatever it takes. Agree to change the nature of your business, if necessary. You know that the next crazy boom will take a different form in any case. All the feds really want to do is to bolt the stable door after the horse is long gone; at least allow them that face-saving measure.
Goldman Sachs is at a crossroads. Either they can significantly change their image in our society or they can face the consequences. All the senators I saw at the hearing on Tuesday were angry, with good reason, with one or more (or all) of Wall Street’s practices.
Senator Ted Kaufman is not a lonely voice any more. He has brought a lot of smart, motivated, and focused mainstream people with him. Goldman should get out ahead of this curve as quickly as possible—and the other big players on Wall Street should do the same. If the megabanks do not take major steps towards making amends (and themselves safer, in a deep structural sense), we are heading for a long and painful (for the banks and their employees) period of confrontation. It is all so unnecessary.
The Republicans Help Reform, Inadvertently (April 26)
No one can publicly oppose what is widely perceived to be “financial reform”—the polls are quite clear on this point. If you want to help Wall Street, your options are:
- Oppose the Dodd bill, claiming that it would create a more dangerous situation than what exists today. But Senator Mitch McConnell already tried this and was thoroughly debunked, e.g., by Senator Ted Kaufman. There will be rhetorical posturing along these lines, to be sure, but there is no sign of any real traction.
- Run a comprehensive “astro turf” disinformation campaign, pretending to be the voice of “true reform.” But these efforts are too obvious at this point—and too obviously fraudulent, so this actually helps the pro-reform narrative.
- Stall for time in terms of preventing the Dodd bill from coming to the floor of the Senate, while working out a backroom compromise that will greatly gut the substance (on consumer protection, derivatives, and/or the resolution authority). This appears to be what the Republicans are focusing on, with Senator Richard Shelby in the lead.
But there is a potential weak point in this Republican strategy.
If the Democratic leadership becomes fed up with Republican stalling—or otherwise sees an opportunity to paint the Republicans as completely obstructionist, they could actually strengthen the bill.
For example, including something like the Brown-Kaufman amendment (or otherwise addressing the issues posed by our six megabanks) would make it easier for people to understand what is at stake. To win on this issue in November, the Democrats may need to simplify their message and make it more powerful. Some relatively pro–Wall Street Democrats are reluctant to do this, but if the Republicans stand united, nothing will pass—so why not propose something stronger that will go down to clear and memorable defeat, particularly after a searing debate?
The Republicans are not the only ones who can maneuver here. By delaying any progress, they are creating an opportunity within the Democratic side to find ways forward that are not entirely designed by Senator Dodd.
The Goldman Sachs appearance between Senator Carl Levin’s subcommittee on investigations is one wild card. President Obama beginning to become more energized and focused on this issue—including at least one speech this week—is another.
Republican stalling tactics have, in effect, introduced a greater element of randomness into the process.
The Republicans obviously want to slow reform or make it change direction. They should be careful what they wish for.
When Will Senator Dodd Take Yes for an Answer? (April 25)
Senator Chris Dodd is a tactical legislative genius—keep this clearly in your mind during the days ahead. In terms of maneuvering for the outcomes he seeks, managing the votes, and controlling the floor, you have rarely seen his equal.
Senator Dodd wants some financial reform—enough to declare victory—but not so much as to seriously undermine the prevalence of megabanks on Wall Street. You can take whatever view you like on his motivation—but Senator Dodd himself is quite open about his thinking and intentions.
Given the mounting pressure from many sides—including Federal Reserve Bank presidents—to implement significantly more reform (see also David Warsh’s Sunday evening assessment, for example) using some version of the Brown-Kaufman SAFE banking act, how exactly will Senator Dodd prevail?
- He knows that the Republican leadership will mount a disinformation campaign, trying to muddy the waters by claiming that the Dodd bill “institutionalizes bailouts.” This top-down Republican line is complete and deliberate misrepresentation—designed purely to prevent real reform. Every time it is repeated, Senator Dodd’s position becomes stronger because people who really want reform need to rally to defend his approach.
- The Republican attacks also justify the Democratic leadership and various pro-reform groups telling people “Don’t confuse the message.” Everyone in the center and on the left is lobbied to emphasize that Senator Dodd’s bill will completely “end too big to fail”—if you deviate from this line, you will be accused of falling in with Mitch McConnell’s dangerous views. Expect this pressure to intensify in coming days—requests for responsible and transparent debate on policy options will be drowned out and pushed aside by the pressure for conformity (underpinned by the desire not to undermine Wall Street campaign contributions too much).
- As the White House pushes back against the Republicans, this will further strengthen Senator Dodd—he is the congressional standard bearer, after all. And everyone knows that he needs 60 senators on his side in order to prevail, so some weakening of the bill is presumed inevitable and must be accepted in the reasonable name of making some progress.
But this is where the pure genius of Senator Dodd enters the equation—with an audacity that makes you whistle with appreciation for the art (although not the substance).
The presumption is that Senator Dodd is negotiating with one or more Republicans who are the easiest to bring on board. This would make sense if Senator Dodd wanted the strongest bill possible.
Senator Chuck Grassley voted for strong derivatives reform in the Agriculture Committee; Senator Olympia Snowe also seems on board with that agenda. Senators John Thune and Bob Corker are saying in public that Republicans want to vote for reform (although it’s a good question what this means exactly). Senator Jim Bunning voted with Senator Bernie Sanders in the Budget committee—on what is being seen as a test vote on breaking up banks (see Sanders’s press release and Huffington Post coverage). Senator Scott Brown is wavering in broad daylight. Senator George Voinovich is retiring and rumored to be flexible on financial reform issues.
But Senator Dodd is closeted in negotiations with Senator Richard Shelby—who stands for the most pro-Wall Street bill possible.
The goal is apparently not to give up as little as possible and still get a bill. The goal is to bring as many supporters of Wall Street as possible on board with the legislation, at the same time framing the issues so the pro-reform camp looks bad when it presses for more.
As we head into what is likely to be the decisive week, Senator Dodd controls the clock, can determine what is debated on the Senate floor, and—whenever he feels hard-pressed—remind everyone to toe his line or fear the extreme Republicans. At this point, only the White House can bring sufficient pressure for the Brown-Kaufman bill to get an up-or-down vote; the odds are against this being what the White House really wants to do. But keep calling the White House and the Senate Democratic leadership.
Two Senators and Larry Summers On Bank Size (April 23)
Bank size is suddenly the issue of the day—with politicians lining up to oppose any meaningful restriction on the size of our largest banks. Their reasoning is varied and all quite flawed, particularly when they insist there must be no Senate floor debate on the Brown-Kaufman amendment.
Senator Dick Durbin may be right to say that the Brown-Kaufman amendment is “a bridge too far” and will not pass in this legislative cycle—presumably this sounds like a tactical political assessment. Surely in that case he would not oppose bringing it to the floor of the Senate and allowing that body to prove him right (or wrong).
Senator Chris Dodd opposes the amendment, but his reasoning is rather vague. Here’s what he says in his interview with Ezra Klein, which appeared yesterday:
“It’s not size; we’re preoccupied with size. And I’m not suggesting that any size is okay, but it’s really risk, it’s these other elements in here. A relatively innocuous product line in a relatively small company can pose huge, systemic risk. That said, in our bill, we provide the authority to break up companies. That is clearly in the bill, the authorization to do that under certain circumstances. But I’m not sure that we ought to become so preoccupied with it. And again, I’ve looked at the 13 Bankers book, and so forth, that approach, and hear this, by the way, not just from them, but from CEOs of major corporations. This is not some left/right question. But I just don’t think that it makes a lot of sense. I don’t think it’ll prevail.”
Senator Dodd is completely correct that this is not a left/right question, and he is also correct that some CEOs and other heavy hitters from the business sector completely agree with us.
But his other reasoning is shaky. No one disputes that risk is the issue here. But our proposal to reduce bank size is in addition to everything already in the bank bill—so in order for this to be a bad idea, you would need to argue that breaking up the big banks would actually lead to more system risk.
Given what we have learned about the serial incompetence of megabanks, with their distorted incentives and perverse belief systems, such an argument seems like quite a stretch. But it is a stretch that Larry Summers—ever the top level debater—understands that the anti-Brown-Kaufman view implies or even requires:
“Brown: The too big to fail issue, why not go further? Why not just limit the size of banks?
Summers: Jeff, that was the approach America took to banking before the depression. That was the approach America took to lending in the thrift sector, before we had the S&L crisis. Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies and hurt the competitiveness of the United States. But that’s not the important issue; they believe that it would actually make us less stable. Because the individual banks would be less diversified, and therefore at greater risk of failing because they wouldn’t have profits in one area to turn to when a different area got in trouble. And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”
There are two substantive points here (ignoring the rhetorical distraction in the first two sentences).
- “Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies, and hurt the competitiveness of the United States.”
- “Because the individual banks would be less diversified, and therefore at greater risk of failing because they wouldn’t have profits in one area to turn to when a different area got in trouble. And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”
I’m not sure who the “most observers” are with regard to either point. I have heard the arguments before but, as we review in 13 Bankers (see the last chapter), neither of these is the mainstream fact-based view regarding big banks.
The idea that breaking up big banks this would “hurt our ability to serve large companies” is often claimed by Jamie Dimon and some other bankers. But it is contradicted and refuted by the CEOs whom Chris Dodd cites. If you find a CFO from a nonfinancial US company who would like to discuss this in more detail (preferably in public, but we also talk to many people off-the-record), send them along—so far, no bankers have accepted our challenge to come out and debate.
On the idea that individual banks are more risky, this is obviously disingenuous. As Summers knows very well, the “risk of failing” depends on the amount of capital that banks have. Large banks have long believed they need less capital because they are well-diversified, but the weaknesses in their thinking were painfully exposed in September 2008.
Again, if you know a top banker who is willing to discuss in public how their risk management systems—broadly and appropriately defined—failed in 2008, and how those flaws have been fixed, please ask them to speak out in detail and with specifics. I understand they may be reluctant to engage in an open debate, but how about at least producing a working paper that has some verifiable evidence in it?
Summers is right that small banks can fail—in fact, they fail all the time in the United States, and he likes the FDIC resolution mechanism so much that he is proposing this as a way to deal with all financial companies (even though it cannot, by definition, work for large cross-border banks because it is not a cross-border authority). We need a financial system in which firms of all kinds can fail—without this, you no longer have any kind of “market” economy.
So the heart of Summers’s claim is that (1) small banks would all fail simultaneously, and (2) this would be more costly to deal with than what we faced in September 2008. Claim (1) is implausible—nothing is that synchronized, including his main supporting episode (the S&L crisis). Claim (2) is also not supported by any evidence—again, the S&L crisis was much less costly than the September 2008 fiasco (and after the S&L episode many people went to jail and even more thrifts went out of business—what’s our score on this round?)
Can Summers really claim, with any credibility, that a set of troubled smaller banks would have got the incredibly generous package of support received by the 13 bankers and their ilk? Of course not; smaller bankers would have been fired, their board of directors would have been dismissed, and their creditors would have faced losses (as with all small bank failures).
And Summers—or others—cannot fall back on the 1930s to say “small banks are bad.” The world has changed fundamentally since that time because we have deposit insurance. The domino collapse of small banks was a result of retail runs.
As I travel round the country presenting 13 Bankers to audiences—including leading experts on these issues, as well as just deeply interested and informed individuals—”most observers” agree that breaking up big banks is an additional measure that would reinforce the Dodd bill and reduce system risk. We agree that breaking up the banks is not sufficient for financial stability—we merely insist that it is necessary, particularly in a political system that has been so completely captured by the biggest bankers.
If you or Larry Summers have any evidence to the contrary, please send it to me. Or just put in on the web in a way that people can assess and critique.
Why is this critical question for our country’s future being fixed up behind closed doors? Why not come out into the open and have a proper public discussion as befits a democratic country?
Even better, let the Brown-Kaufman bill come to the Senate floor for a debate and an up-or-down vote. What exactly are the opponents of this suggestion afraid of?
Greece, the IMF, and What Comes Next (with Peter Boone/April 23)
The latest developments from Europe—including Greece appealing for an IMF program today—may well be a watershed, but if so, it is not a good one. The key event yesterday was that the yield on all the debt of weak eurozone governments widened while German yields fell. The spreads show all you need to know: a very clear and large contagion risk.
The 5-year Portuguese yields rose from 3.84 percent to 4.26 percent. The 5-year Spanish bonds rose from 2.89 percent to 3.03 percent, and the 5-year Irish bonds rose from 3.74 percent to 3.97 percent. These are not minor moves for investment grade sovereign bond funds. This kind of change means, for example (and roughly), you lose 0.5 percent on the value of a bond in one day. These are bonds that just pay 3 percent per year—and one such day may be enough to cause “investment grade investors” to decide not to stay involved and not to come back for a long while.
If these bonds transition towards being held by “emerging market investors” (usually quite different people), and stronger European commercial banks decide to limit their exposure to the weaker government’s bonds, we could be in for quite a major increase in yields across the spectrum.
Emerging market investors look at these weaker eurozone bonds—compared to say Argentina with 10 percent yields—and think they represent unappealing reward for the risk. Greek 5-year bonds rose to 9.4 percent yesterday from 8.1 percent the previous day. This is still low for a country on the verge of default.
These higher government bond yields are also hitting banks. No doubt there is a bank run on in Greece to some extent at the wholesale level. This will spread to other banks in the region. Since their marginal funding costs are tied to the creditworthiness of the sovereign, and since the collateral for these banks’ portfolios is tied to local property values and assets, these changes in sovereign yields will have a negative impact on banks’ balance sheets.
Irrespective of the next move—which lies this weekend with the International Monetary Fund and the ministers of finance meeting in Washington for the Fund’s spring meetings—this looks like the moment when the Greek problems really start to generate contagion across the eurozone region. We’ll see rates on government debt trending higher, asset prices (such as real estate) falling even more, and renewed concern about banks on the European “periphery.”
What can the authorities do? The only path is a new package of “liquidity assistance” for countries under pressure but not yet ready to call in the IMF. The liquidity is available from the ECB—it can provide emergency loans to all the banks in the region to prevent bank runs from toppling them. But there is also a solvency problem for the weaker countries now under pressure.
To return to solvency, the struggling eurozone countries will need funding for budget deficits and debt rollover for several years. Governments will need to recapitalize their banks with new government-backed debt. The best solution would be for the government to then sell their stakes to larger European banks with more creditworthy sovereigns. SocGen Greece (with all its issues) would be a lot more attractive to Greek businessmen and depositors than National Bank of Greece at the end of all this.
And this is the heart of the problem: Will Germany and other European nations be prepared to provide the large sums needed to refinance several peripheral nations? Will these nations then take the painful austerity measures needed in the midst of recessions in order to get out of this?
When the problem was just Greece, the numbers were already large. In our view, the Greek government needs 150 billion euros over three years to be sure it can refinance itself through a recession. The Portuguese will roughly need 100 billion euros. If those amounts were made available—will that support the confidence needed to buy Irish and Spanish bonds, or would it scare investors because the protests from Germany would be so large that it would be clear no more funds would be available in bailout mechanisms?
There is no easy answer to this question, but yesterday’s action suggested that markets are not at all confident policymakers are going to stop this crisis soon. They are surely right: Greek strikes, a weak Portuguese government deeply in denial, and German hatred for bailouts all make a path to restore confidence very difficult.
Yesterday was also a wake-up call for the United States. It is no longer reasonable or responsible to say: “US banks have no exposure to Greece.” US banks are heavily exposed to Europe, and this is turning into a serious Europe-wide problem. The United States badly needs to make sure this does not spread beyond Greece and Portugal/Ireland.
To restore confidence in buying Spanish and other major European nation bonds, it would surely help to have clear signals that President Obama himself, and the Federal Reserve, are taking an active stance now on making sure this does not spread to become another threat to global financial stability. A broader wall of preventive financing must now be put in place—after all, this is exactly why (in principle) the IMF was recapitalized this time last year.
Such a push by the United States would be awkward, to be sure, as the French and Germans (and British) are not keen to have more US involvement in their affairs. But the Europeans have handled matters so badly in the past few months, it is time for a much more scaled-up US role.