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Greece and the Fatal Flaw in an IMF Rescue



In 2003 the International Monetary Fund published yet another internal review with an impressively dull title "The IMF and Argentina, 1991–2001 ." But hidden in that text is explosive language and great clarity of thought—in essence, the IMF staff belatedly recognized that their decision to repeatedly bailout Argentina from the mid-1990s through 2002 was wrong:

"The IMF should refrain from entering or maintaining a program relationship with a member country when there is no immediate balance of payments need and there are serious political obstacles to needed policy adjustment or structural reform" (page 7, recommendation 4).

If Jean-Claude Trichet (head of the European Central Bank), Angela Merkel (German Chancellor), and Nicolas Sarkozy (French President) have not reviewed this document yet, they should skim it immediately. Because one day soon Greece will be calling on the IMF for a loan, and it seems most likely that the mistakes made in Argentina will be repeated.

There are disconcerting parallels between Argentina's catastrophic decade, 1991–2001, which ended in massive default, and Greece's recent and impending difficulties. The main difference being that Greece is far more indebted, is much less competitive in global markets, and needs a commensurately greater fiscal and wage adjustment.

At the end of 2001, Argentina's public debt-to-GDP ratio was 62 percent, while at end 2009 Greece's was 114 percent. Argentina's public deficit reached 6.4 percent GDP in 2001, while Greece's was 12.7 percent GDP (or 16 percent on a cash basis) in 2009. Both countries locked themselves into currency regimes, which made it extremely painful to exit: Greece has the euro, while Argentina created a variant of a currency board system tied to the US dollar. And both countries had seen their competitiveness, as measured by the "real exchange rate" (which reflects differential inflation relative to competitors) worsen by 20 percent over the previous decade, helping price themselves out of export markets—and boosting their consumption of imports. In 2009 Greece had a current account deficit equal to 11.2 percent of GDP, while Argentina's 2002 current account deficit was a much smaller 1.7 percent of GDP.

The solution to such crises is rarely gradual. Once financial market confidence is lost, yields on government debt soar, private capital flees, and sharp recessions occur. The IMF ended up drawing tough conclusions from its Argentine experience—the Fund should have walked away from weak government policy programs earlier in the 1990s. Most importantly, IMF experts argued that from the start the IMF should have prepared a plan B, which included restructuring of debts and termination of the currency board regime, since they needed a backstop in case the whole program failed. By providing more funds, the IMF just kicked the can a short distance down the road, and likely made Argentina's final collapse even more traumatic than it would otherwise have been.

Sadly, the Greeks are today in a similar situation: the government's macroeconomic program is not nearly enough to calm markets or put Greece's debt on a sustainable path. By 2012 we estimate Greece's debt/GDP ratio will rise from 114 percent of GDP to over 150 percent. The interest payments alone on this would amount to 9 percent of Greek's incomes at current rates, and almost all those funds are transferred to the German, French, and Swiss debt holders.

Greece's 2010 "austerity" program is striking only for its lack of credibility. Under that program Greece, even in 2010, does not pay the interest on its debt—instead the government plans to raise 52 billion euros in credit markets to refinance all its interest while at the same time it borrows 4 percent of GDP more. A country's "primary budget" position measures the budget without interest expenses—at the very least, the Greeks need to move from a 4 percent of GDP primary budget deficit to a 9 percent of GDP primary surplus—totaling 13 percent of GDP further fiscal adjustment, in the midst of what will be a massive recession, just to have enough funds to pay annual interest on their 2012 debt. This is under the rather conservative assumption that interest rates would settle near 6 percent per year, where they stand today. The message from these calculations is simple: Greece needs to be far more bold if its austerity program is to have a serious chance of success.

How did Greece manage to get into such a terrible situation? Local politics that lead to profligate spending is one answer. But remember that someone needs to supply the money that allows such profligacy. In this case it was the European Central Bank (ECB) that handed Greece the keys to the safe.

The Reason Mr. Trichet Wants Europe to Stand Tough Against Greece

This may not be obvious, but, creating money in a currency union is no simple task. In any single country, central banks usually restrict themselves to buying government bonds, and making loans to regulated commercial banks. Net purchases of these securities by central banks create what is called "high-powered money"; this feeds into the financial system and results in the creation of what we all use to make payments and store value, i.e., money: plain and simple.

However in the European Monetary Union there are now 17 nations and a plethora of banks. So, to put it crudely, there is sure to be a fight to decide who gets the newly printed funds. The ECB resolved this by what seemed like a fair rule: All commercial banks can borrow from the ECB if they provide collateral, in the form of highly rated government and other securities, to the ECB. So, for example, a Greek bank can gain liquidity by depositing Greek government bonds with the ECB—as long as those bonds are "investment grade," i.e., highly rated.

This simple and seemingly reasonable rule created great dangers for the eurozone, which have come back to haunt Mr. Trichet. The commercial banks in the zone are able to buy government bonds, which "paid" 3 to 6 percent long-term interest rates (for all the sovereign bonds of members) over the last decade, and then deposit them at the ECB. They could then borrow from the ECB at the ECB financing rate, which today is 1 percent, against this collateral while pocketing a profit—and then buy more sovereign bonds with the funds. Mr. Trichet recognized this system had inherent dangers of turning into a new Ponzi game: if nations spent too much, and built up too much debt, eventually the system would collapse. So at the foundation of the eurozone, Mr. Trichet led a contingent within the European Union that demanded all nations live by a "Growth and Stability Pact," whereby each nation could only run deficits of 3 percent of GDP, and they had to keep their debt/GDP ratio below 60 percent of GDP.

Of course, politics trumped Mr. Trichet—as it always must—and the Greeks, along with the Portuguese, used their newfound cheap lending system to run large deficits and build up debt. The cheap access to money also helped feed the real estate booms in Ireland and Spain.

Today, Mr. Trichet and Ms. Merkel are desperate for harsh changes to ECB lending rules that will stop this Ponzi game. They want to penalize profligate spenders. They also want profligate nations to pay more interest. Soon, because of its poor credit rating, Greek debt will be treated like poor collateral, so banks will no longer be able to borrow as much with Greek debt as collateral. When these changes at the ECB come into effect in 2011, the days of Greece being able to borrow easily at low interest rates in the eurozone will close once and for all.

As protector of the eurozone, the ECB does not want to see large bailouts to nations that abused the system. Marko Kranjec, an ECB council member, recently made the ECB view clear: "Membership in the [e]uro region dictates a special discipline….only noneuro region EU members, such as Hungary, Latvia and Romania, are eligible for financial aid." The noneuro members get aid because they do not have access to the ECB lending window, but, if you abuse that window, you will not get extra help.

If Greece needs to pay more for its debt, the debt dynamics become ever more unsustainable. What interest rate should markets charge for a nation that has 120 to 150 percent public debt/GDP ratio, a large budget deficit, a recessionary uncompetitive economy, and a bloated public sector that stages frequent and often violent strikes? The answer is probably around what Argentina paid in the late nineties: 10 percent per year. But as Greece's Prime Minister is fully aware when he calls for lower interest rates, Greece cannot afford these rates—their budget would simply collapse.

If They Are Permitted to Be Candid, What Choices Would the IMF Staff Present to Greece?

So when the Greeks soon turn up at the IMF, what will the IMF say? If politics did not circumvent rational economics, the choices are clear:

Choice 1: True Fiscal Austerity—10 Percent of GDP, with Further Measures Soon

To gain confidence in markets, the Greeks need to demonstrate that they are prepared to actually stop the rapid rise of their debt relative to income. This means running a primary surplus in short order.

For Greece to achieve this, the numbers required are, simply put, staggering. Lower public spending and higher taxes will lead to a sharp contraction in demand, and it will have repercussions as businesses in Greece see less follow-on spending. Ultimately, every $1 of fiscal tightening may generate $1.50 to $2.00 in lost domestic demand. Fiscal tightening only works if the new unemployment leads to wages and prices falling, thereby making a nation more competitive. The jury is out whether Greek unions would permit such large wage reductions, but the whole process will surely take several years. So, in the first year or two, we could expect Greek GDP to fall sharply with a strong austerity program.

This is where the problems set in—and the risk of a vicious downward cycle. Lower GDP means lower tax revenues, and higher unemployment benefits, and all these things worsen the budget. Under reasonable assumptions, if the Greeks took an initial 10 percent of GDP in further fiscal measures, they would still run a budget deficit in 2011 of approximately 5 percent of GDP. This deficit would fall as the economy recovered later, and if unemployment fell, but that could take a long time.

We doubt such an austere program could work, and even if it did, someone needs to finance Greece's budget deficit, and roll over their debt, for three or more years. Markets would undoubtedly be concerned by sharp output declines and ongoing strikes. The only solution would be for the European Union and IMF to step up and effectively guarantee three years of financing needs, or $150 billion in total. That is seven times the whisper numbers that the European Union is currently considering providing to Greece.

Choice 2: Sovereign Default but Keep the Euro

The second choice means admitting that the fiscal situation is just too painful to solve: Greece would default on its debt and call a stop to all interest and principal for, say, two years.

The default on debt would have major ramifications. The government would need to take actions to avoid a run on all the Greek banks—this would need to be coordinated with the ECB to ensure there was liquidity support. Private creditors would pull loans wherever possible from Greek entities. In short: Greece would suffer a large financial and economic collapse, and GDP would decline substantially.

This financial collapse would mean Greek debt would need to be written down substantially. We would guess that a 65 percent write down of face value, bringing total Greek debt to around 50 to 60 percent of a lower new GDP, would be reasonable. Such write downs roughly match the terms that Argentina received after its debt restructuring.

This draconian cut to government debt would not solve Greece's problems. It would still need to cut budget spending in order to lower the deficit—and in the aftermath of defaults, there are generally few sympathizers. Greece could save on interest (which to date it never paid in any case), but it would not be a panacea for the budget or economy.

Choice 3: The IMF's Plan B—Debt Default and Exit the Eurozone

Faced with a collapsing banking system that comes with default on sovereign debt, there is good reason to call for Greece to, at least temporarily, give up the euro. The advantage of moving to a different currency would be that Greece could generate a rapid increase in competitiveness, and so speed up its transition. The government could offer to restructure debt into this new currency, or into euros at a much larger haircut. The bloated costs of the public sector could be eroded through inflation in the new currency. This should make it possible to move quickly to a budget surplus and an external surplus.

In Argentina, the government partially indexed deposits at banks, but they forced the deposits to be converted to pesos from dollars. They similarly required that all domestic debt be converted, and they negotiated a sharp reduction in external debt while offering those debt holders the ability to convert debt into pesos.

Argentina's economic collapse ended roughly six months after they defaulted and ended their peg. While it was painful, the economic recovery started rapidly; nine months after default and devaluation, GDP began growing rapidly. This is a trend that continues even today. The same lesson, that large devaluations and default can result in rapid recoveries, was observed in Russia in 1999 and in the aftermath of the Asian crises.

Greece's recovery would take longer, because they have not yet had many of the adjustments that are needed, but they could probably expect a recovery to decent growth starting H2 2011.

The IMF Leadership Will Want to Muddle Through, but Will Merkel and Trichet Play Ball?

Will the IMF prepare a program with drastic fiscal cuts, sticking to the lesson it learned from Argentina, in order to bring the nation back into solvency? Will they turn to the European Union and be blunt: either you need to be prepared to provide Greece 150 billion euros of loans over three years as credit lines, at low interest rates so they can afford it, or the program will be underfunded. Will they walk away from any program if the European Union does not promise large enough funding and the Greeks do not promise drastic enough cuts? And, would they dare to discuss a "plan B" for Greece, as their own internal review suggested would have been best for Argentina back in the nineties?

The answer to all this seems very clear. The IMF will agree to another program that is very likely to fail, just like they did in Argentina. There are some obvious reasons why this is likely. One reason is that it is easy to hide behind a veil of probabilities. Of course there is some chance that Greece might make it out with little change, so why not wait and see if it works? The trouble is the odds, for Greece, are slim. It is impossible to say exactly what the odds are, but suffice it to say, Greece's external debt and current fiscal difficulties, while tied into a fixed exchange rate regime, mean that nation needs far harsher adjustments than any of the sovereign major defaulters of the last 50 years. We cannot think of one comparable example of success. The social and political divisions in Greece, along with the penchant for debilitating strikes, also reduce the odds for success.

(Some people suggest Ireland is an example. However, Ireland started with much lower debt levels and, despite large fiscal cuts, they are still running a deficit over 10 percent of GDP that requires annual financing and a rapid build-up of sovereign debt. Greece could not get these funds in markets, and they will have trouble repaying that new debt just like the old.)

Meanwhile, the longer we wait for real fiscal adjustments, the more Greece builds up debts and so needs an ever larger adjustment later. Such an end could be enormously disruptive: Imagine nationwide strikes, violence, and chaotic default. Consider the burden on others: While Greece marches on building up debt and sinking ever deeper into problems, how can we expect creditors to feel comfortable lending to Portugal, Ireland, or Spain? The whole eurozone will suffer if Greece defaults and it will suffer if Greece does not default. The IMF concluded that Argentina had a window in the late nineties when they could possibly have escaped their burdensome debt and currency peg in a planned move—but they missed it. The eurozone arguably has a chance now to deal resolutely, one way or another, with this problem before the chronic pain impacts others.

There are also powerful personal interests that will guide these decisions. Dominique Strauss-Kahn, current head of the IMF, is widely believed to be focused on becoming the next president of France. It will not look good—to the French electorate—if the IMF is seen forcing a Greek default, or if it demands that the Europeans provide over a hundred billion euros of long term financing. So, if a political calculation is on his mind, he would want to offer a lax short-term program, backed up by promises for "greater austerity in the future if needed." Greece will march on, mired in recession, with its debt stock growing as the IMF and European Union fund them. The private sector, as in the case of Argentina, will simply not want to touch their debt. Dominique Strauss-Kahn could then declare his candidacy in early 2011, resign from the Fund, and let his successor force the true austerity—at which time Greece would suffer ever more under any solution.

It is also in the interests of most other members of the eurozone to just "kick the can down the road." The other debt-laden periphery nations are naturally terrified of a Greek collapse that will spill over to their nations. They will now lobby hard for the IMF to be generous, and they will be satisfied with partial steps. Perhaps this will give them time to prepare, but more likely, they will just kick the can down the road themselves—as the Portuguese seem to be doing with their lax fiscal budget announced for 2010. These nations surely underestimate how much worse this may get, and they continue to suckle on the cheap credit window that the ECB has, until now, kept open to them.

The Fight Begins: Will Europe's "Euro Visionaries" and the Austere Germans Force Hard Decisions Today?

However, there are two groups in the eurozone who may still not play this game. Ms. Merkel knows German taxpayers would loathe any kind of Greek bailout, and Germans inherently care more about the long-term stability of the euro than any other nation.

It is, undoubtedly, in the ECB's and Germany's long-term interest to force Greece to take tough medicine now, or, to default on their sovereign debts and leave the eurozone. Having one member be forced out of the eurozone will send a clear message to others.

There are many nations now waiting on the sidelines: How can Mr. Trichet and the Germans feel comfortable that new entrants will not copy the Greek Ponzi game once they gain access to ECB's funding windows if the new entrants see Greece get a new large loan package at subsidized interest rates? The ECB should be rightly concerned that such actions would only make fiscal probity, and therefore monetary policy, far harder to control in the eurozone.

Where Next for Greece?

Mr. Trichet understands that Greece's problems reflect a dangerous flaw in the eurozone system, and the solution will set the tone for behavior of other members for years to come. He'll want his pound of flesh before this is done. The IMF staff surely understands that Greece's economic problems are critical, and require drastic actions, but the IMF's managing director may just want to survive to be elected a new president of France in 2012.

The German population detests providing bailouts to periphery nations, while the debtors of the eurozone would like the same game to continue a little bit longer. Meanwhile, the Greeks continue to drag their feet on serious reform while claiming to be "courageous"—presumably they are hoping, magically, that markets will start to want to lend to them again at very low rates in the midst of a fiscal program with little hope for long-term success. It all seems horribly reminiscent to those early days when Argentina slid toward a cruel collapse.

Also posted on Simon Johnson's blog, Baseline Scenario. Following were previously posted:

Larry Summers: "Senator Kaufman Is Exactly Right"

April 7, 2010

Senator Ted Kaufman (D-DE) has given three blistering speeches recently, individually and collectively cutting to the heart of the financial reform matter: the deregulation of finance has gone too far and big banks now need to be reined in; the continued prevalence of fraud among Wall Street's biggest bankers; and why the administration's proposed "resolution authority" would do nothing at all to end the problems associated with too big to fail financial institutions.

You might think no one listens to Senate floor speeches, but you'd be wrong. Sunday on This Week (ABC), Jake Tapper asked Larry Summers—head of the White House National Economic Council and key strategist on financial reform—point blank about one of Senator Kaufman's most important points.

Summers started this part of the interview with a fiery anti–finance industry moment, citing their lobbying spending against financial reform ("$1 million per congressman") and arguing that the legislation currently before Congress will provide basic consumer protection, more effective regulation, and the ability to handle the failure of large financial firms. "How can anyone take the position...that we don't need comprehensive financial reform?"

To which, Jake Tapper responded, "Some Democrats say it doesn't go far enough. Here's Delaware Democrat Ted Kaufman talking about the Dodd bill."

Kaufman: Unless Congress breaks up the megabanks that are too big to fail, the American taxpayer will remain the ultimate guarantor of an almost certain to repeat itself cycle of boom, bust, and bailout.

Tapper: Senator Kaufman is saying that there isn't being—enough being done about too big to fail. In 2000, you said, quote, "It is certain that a healthy financial system cannot be built on the expectation of bailouts." Can you honestly say that the Dodd bill changes that?

Summers: Yes, I can. It changes—it reduces the expectation of bailouts by insisting that institutions have much more capital so they won't need to be bailed out. It eliminates the prospect of bailout by creating a framework in which a failure can be managed with creditors taking responsibility. It restricts—and this was the important point that former Fed Chairman Paul Volcker has stressed—it restricts the so-called proprietary trading activities, some of the most risky activities of these institutions. So, yes, this bill is a direct attack on too large to fail by making failure a possibility, as it has to be in a market system, and by making these institutions much safer and much sounder. Senator Kaufman is exactly right.

Larry Summers is incorrect on three important dimensions of the Dodd legislation: it doesn't "insist institutions have much more" capital requirements; it doesn't "restrict proprietary trading activities" in any meaningful fashion; and it doesn't "eliminate the prospect" of a bailout. For the details on all these issues, review the three Kaufman speeches linked above—these are now essential reading for anyone who wants to grasp what really needs to happen.

The White House rhetoric on financial reform is moving in the right direction. But there is growing dissonance between what the White House says it is supporting and what is really in the legislation.

Mr. Summers and other leading representatives of the administration should move to recognize and correct this dissonance. Either they should work hard to strengthen the legal provisions, along the lines stressed by Senator Kaufman, or they should be more honest—i.e., they do not think that "too big to fail" is really such an important problem, or they are afraid that big banks would react by contracting credit (this is essentially what Jamie Dimon threatens at the end of his letter to shareholders last week).

If the White House continues down the path of endorsing reform while not really pushing for meaningful change, the financial reform conversation will become increasingly uncomfortable for them.

Passing a bill that contains mostly mush is not a good idea—it would only further the perception (and the reality) that this administration is far too close to certain "savvy businessmen" on Wall Street.

The coming legislative debate will clearly divide people into "for" and "against" our massive global banks that have so manifestly gone bad. For the last time: Which side does the president really want to be on?

The Toughest Foe of Reform in America: Jamie Dimon

April 3, 2010

There are two kinds of bankers to fear. The first is incompetent and runs a big bank. This includes such people as Chuck Prince (formerly of Citigroup) and Ken Lewis (Bank of America). These people run their banks onto the rocks and end up costing the taxpayer a great deal of money. But, on the other hand, you can see them coming and—if we ever get the politics of bank regulation straightened out again—work hard to contain the problems they present.

The second type of banker is much more dangerous. This person understands how to control risk within a massive organization, manage political relationships across the political spectrum, and generate the right kind of public relations. When all is said and done, this banker runs a big bank and—here's the danger—makes it even bigger.

In the second category, Jamie Dimon is by far the most formidable American banker of this or any other recent generation.

Not only did Mr. Dimon keep JPMorgan Chase from taking on as much risk its competitors, he also navigated through the shoals of 2008–09 with acuity, ending up with the ultimate accolade of "savvy businessman" from the president himself. His letter to shareholders, which appeared this week, is a tour de force—if Machiavelli were a banker alive today, he could not have done better. (You can access the full letter through the link at the end of the fourth paragraph in this WallStreetJournal blog post; for another assessment, see Zach Carter's piece.)

Dimon fully understands—although he can't concede in public—the private advantages (i.e., to him and his colleagues) of a big bank getting bigger. Being too big to fail—and having cheaper access to funding as a result—may seem unfair, unreasonable, and dangerous to you and me. But to Jamie Dimon, it's a business model—and he is only doing his job, which is to make money for his shareholders (and for himself and his colleagues).

Dimon represents the heavy political firepower and intellectual heft of the banking system. He runs some of the most effective—and tough—lobbyists on Capitol Hill. He has the very best relationships with Treasury and the White House. And he is determined to scale up.

The only problem he faces is that there is no case at all for banking of the size and form he proposes. Consider the logic he presents on page 36 of his letter.

He starts with a reasonable point: Large global nonfinancial companies are an integral and sensible part of the American economic landscape. But then he adds three more steps:

  1. Big companies need big banks, operating across borders, with large balance sheets and the ability to execute a wide variety of transactions. This is simply not true—if we are discussing banking at the current and future proposed scale of JPMorgan Chase. We go through this in detail in 13 Bankers—in fact, refuting this point in detail, with all the evidence on the table, was a major motivation for writing the book. There is simply no evidence—and I mean absolutely none—that society gains from banks having a balance sheet larger than $100 billion. (JPMorgan Chase is roughly a $2 trillion bank, on its way to $3 trillion.)
  2. The US banking system is not particularly concentrated relative to other Organization for Economic Cooperation and Development (OECD) countries. This is true—although the degree of concentration in the United States has increased dramatically over the past 15 years (again, details in 13 Bankers) and in key products, such as credit cards and mortgages, it is now high. But in any case, the comparison with other countries doesn't help Mr. Dimon at all because most other countries are struggling with the consequences of banks that became too large relative to their economies (e.g., in Europe; see Ireland as just one illustrative example).
  3. Canada did fine during 2008–09 despite having a relatively concentrated financial system. Mr. Dimon would obviously like to move in the Canadian direction—and top people in the White House are also very much tempted. This is frightening. Not only does it represent a complete misunderstanding of the government guarantees behind banking in Canada (which we have clarified here recently), but this proposal—at its heart—would allow, in the US context, even more complete state capture than what we have observed under the stewardship of Hank Paulson and Tim Geithner. Place this question in the context of American history (as we do in chapter 1 of 13 Bankers): If the United States had just five banks left standing, would their political power and ideological sway be greater or less than it is today?

For a long time, our leading bankers hid behind their lobbyists and political friends. It is most encouraging to see Mr. Dimon come out from behind those layers of protection, to engage in the intellectual fray.

It is entirely appropriate—and most welcome—to see him make the strongest case possible for keeping banks at their current size and, in fact, for making them bigger. We should encourage such engagement in public discourse, but we should also examine carefully the substance of his arguments.

As we point out in the Washington Post "Outlook" section this week, Theodore Roosevelt carefully weighed the views of J. P. Morgan and other leading financiers in the early twentieth century—when they pushed back against his attempts to rein in their massive railroad and industrial trusts. Roosevelt was not at that time against big business per se, but he insisted that big was not necessarily beautiful and that we also need to weigh the negative social impact of monopoly power in all its economic and political forms.

If we don't find our way to a modern version of Teddy Roosevelt, Jamie Dimon—and his successors—will lead us into great harm. It's true that, after another crash or in the midst of a Second Great Depression, we can reasonably hope to find another Roosevelt—FDR—approach. But why should we wait when such a disaster is completely preventable?

Contradicting Secretary Geithner

April 2, 2010

Speaking Thursday morning on the Today Show, Treasury Secretary Tim Geithner insisted on two points:

1. If the bank rescue of 2008–09 had been handled in any other way—for example, being tougher on bankers—the costs to the real economy would have been substantially higher.

"Again, what was the choice the president had to make? He had to decide whether he was going to act to fix [the banking system] or stand back because it might be more popular not to have to do that kind of stuff, and that would have been calamitous for the American economy, much, much worse than what we went through already."

2. The reform legislation currently before Congress would end all concerns regarding too big to fail in the future.

"The president's not going to sign a bill that doesn't have strong enough teeth."

In 13 Bankers, we disagree strongly with point number 1 (see this excerpt) and find point number 2 so at odds with reality that it is scary. Friday morning, also on the Today Show, I have a brief opportunity to suggest a different narrative.

First and foremost, it is impossible to believe that the government could not have been tougher on banks and bankers in spring 2009. The idea that every failed top banker needed to keep his job—and that every director of a failed bank needed to stay in place—is simply preposterous.

Of course, the people who ran our biggest banks onto the rocks think they are indispensable, but as Charles de Gaulle reportedly said, "The cemeteries of the world are full of indispensable men."

This is not about being vindictive. This is about holding people accountable. We argue in 13 Bankers that the government could have taken over big insolvent banks—and applied a Federal Deposit Insurance Corporation (FDIC)-type resolution process. At the very least, top management and boards of directors at failed banks—i.e., all those rescued by the government—should have been fired.

Not only that—but all those people should have had their contracts broken and their bonuses clawed back to the full extent possible. Losing personal money is the only thing that modern American financial executives ultimately understand. And if that was breach of contract—let them sue and good luck to them in court; just think of the extra evidence for wrongdoing that would uncover.

The costs of this excessively nice approach are enormous. "[I]t is certain that a healthy financial system cannot be built on the expectation of bailouts"—that's what Larry Summers said in his 2000 Ely Lecture to the American Economic Association, and it's true (see the American Economic Review, Vol. 90, No. 2). Now we have a system where the biggest banks expect to be saved—come what may—and the credit markets share that view. This is monstrously unfair and extremely dangerous.

In fact, it's exactly the kind of financial structure that Larry Summers railed against in 2000—that lecture was mostly about "emerging markets" and how they get into repeated financial crises. This is where the United States is now heading.

As for the financial reform bill now before Congress, Secretary Geithner is completely wrong if he thinks it "has teeth." There is simply nothing there that will rein in our largest financial institutions—and you can see this in the financial markets. Even as some sort of legislation moves closer to passing, massive banks retain their funding advantage—and continue to look for ways to get larger (see Jamie Dimon's letter to his shareholders this week).

And as a symptom of these continuing problems, see the latest round on executive pay at banks—we're back to cash and other short-term oriented payouts. This administration recognizes that such incentives are dangerous—particularly when combined with implicit government guarantees. But they can do nothing—and will do nothing—about this or about the deeper underlying issues.

The biggest and most dangerous elements of Wall Street have taken over Washington.

Paul Volcker: Do the Right Economic Thing

March 31, 2010

A great deal of the popular anger directed at big banks is completely legitimate, as put nicely by John Cassidy at the end of his interview with Treasury Secretary Tim Geithner:

"The hardest part of his job, Geithner often says, is getting people to comprehend the inner logic of a financial-rescue operation, and the unpopular actions it entails. In fact, his problem may be not economic illiteracy but its opposite: Americans understand all too well what has happened. Financial crises have a way of revealing aspects of our economic system that otherwise remain obscured, such as the symbiotic relationship between Wall Street and Washington, the hidden subsidies that financial firms sometimes receive from the Fed and other government agencies, and the fact that the vast profits that firms like JPMorgan Chase and Goldman generate depend in part on an implicit guarantee from the taxpayer. When ordinary Americans are confronted with these realities, they get angry."

Paul Volcker is also angry.

Of course, Paul Volcker expresses himself in the measured language of a distinguished technocrat. But he is very worried about our current financial structure and where it is heading. Speaking March 31 at the Peterson Institute in Washington, DC, Mr. Volcker made two broad points (Marketwatch coverage)—both of which we also emphasize in 13 Bankers.

1. The financial sector does not add anywhere near as much social value as its proponents claim.

"The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector—in compensation and profits—reflect the relative contributions that sector has made to the growth of human welfare" (from New York Times story).

2. Too big to fail banks are alive and well—and this poses a major problem to our future prosperity.

"There is an expectation that very large and complicated financial institutions will not be allowed to fail," he said. "Unless that conviction is shaken, the natural result is that risk-taking will be encouraged and in fact subsidized beyond reasonable limits."

The message at PIIE and from other statements made by Mr. Volcker is clear. Our biggest banks are out of control and will not be reined in by the measures currently on the table. We need a much stronger approach to big banks—an approach that will strip government-backed banks of their ability to take crazy risks and, most likely, an approach that significantly constrains (and hopefully even reduces) their size.

Geely Buys Volvo: Goldman Gets the Upside, You Get the Downside

March 30, 2010

Geely Automotive has acquired Volvo from Ford. This is a risky bet that may or may not pay off for the Chinese auto maker—after first requiring a great deal of investment.

Goldman Sachs' private equity owns a significant stake in Geely, with the explicit goal of helping that company expand internationally. Remember what Goldman is—or rather what Goldman became when it was saved from collapse by being allowed to transform into a bank holding company in September 2008 (which allowed access to the Federal Reserve's discount window, among other advantages). Goldman's funding is cheaper on all dimensions because it is perceived to be too big to fail, i.e., supported by the US taxpayer; this allows Goldman to provide more support to Geely (and others).

Our too big to fail banks stand today at the heart of global capital flows. People around the world—including from China—park their funds in the biggest US banks because everyone concerned believes these banks cannot fail; they were, after all, saved by the Bush administration and put completely—gently and unconditionally—back on their feet under President Obama. These same banks now spearhead lending to risky projects around the world.

What is the likely outcome?

We know that risk management at the megabanks breaks down in the face of a boom (remember Chuck Prince of Citigroup in July 2007: "as long as the music is playing, you've got to get up and dance. We're still dancing"). We know there is a growing boom in emerging markets—including through the overseas expansion of would-be multinationals from those countries. This is most notably true of state-backed firms from China, but there is also a more general pattern (think India, Brazil, Russia, and more).

The big global banks, United States and European, are charging hard into this space—Citigroup is expanding fast in China and India (areas where they claim great expertise); and the CEO of HSBC has moved to Hong Kong. Many investment advisors are adamant that China will power global growth (never mind that it is less than 10 percent of the world economy), that renminbi appreciation is around the corner, and that the value of investments in or connected to that country can only go up.

There is a very good reason why between the 1930s and the 1980s large US commercial banks were severely constrained in their risk-taking activities. By the 1930s US policymakers had learned the very hard way that we do not want the banks that run our payments system (with the implicit or explicit backing of the government, depending on how you look at it) to be engaged also in high-risk equity-type investments—this is really asking for trouble.

The problem is not that all such banking-based risky investments go bad. Far from it—we'll first get an apparently great boom, which will suck in all kinds of financial institutions, our future Chuck Princes. As long as the market goes up, the executives and traders involved will do very well—lauded as geniuses and paid accordingly.

And if some of them fail, so what—failure is essential to a market economy. But here's the key problem with having so much of our economy in the hands of financial firms that are too big to fail. When the next emerging market crash comes, we'll have to make the 2008–09 decision all over again: should we rescue our big, troubled financial institutions or should we let them fail—and cause great damage to the economy?

In our assessment (13 Bankers: The Wall Street Takeover and the Next Financial Meltdown), based on the details of financial deregulation over the past 30 years, the prevailing belief system of top bankers, and the big banks' incentives to take risk, we are all heading for trouble. The "financial reform" legislation currently before Congress and still prevailing pro-banker attitudes at the top of the Obama administration are really not helpful. The country's course was set by a fateful meeting at the White House last March; a resurrected, unreformed, and still crazy system—symbolized by 13 Bankers—is in the driving seat now.

At best, this will be another very nasty boom-bust-bailout cycle. At worst, we are heading toward a situation in which our banks are so massive that when they fail, there is no way the government (or anyone else) can offset the damage that causes.

This time our government debt (held by the private sector) will roughly double—increasing by 40 percentage points of GDP—as a direct result of what the banks did. We've lost more than 8 million jobs since December 2008—for what good reason? Next time could easily be worse.

You can disagree with our analysis—provide your own facts and figures, and we'll have that debate here or elsewhere; the more public the better from our perspective. And you should certainly want to improve on our policy prescriptions. We put forward some simple ideas that can be implemented and would help—our versions can also be communicated and argued widely: If banks are too big to fail, making them smaller is surely necessary (although likely not sufficient).

But don't ignore the question. Don't assume that this time Goldman and its ilk will avoid getting carried away—they are just doing their jobs, after all, and their job description says "make money"; system stability is someone else's job.

And also don't presume that just because the big banks and their friends seem to hold all the cards they will necessarily prevail in the future.

In all previous confrontations between elected authority and concentrated financial power in the United States, the democratic element has prevailed (see chapter 1 in 13 Bankers; also Monday's Wall Street Journal, behind the paywall). This can happen again—but only if you stay engaged, argue this out with everyone you know (including your elected representatives), and help change the mainstream consensus on banking definitively and irrevocably.

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