The Speech for Which We Have Been Waiting

For nearly two years now we have waited for a speech. We need a simple speech and a direct speech—most of all a political speech—about what exactly happened to our financial system, and therefore to our economy, and what we must do to make sure it can never happen again.

President George W. Bush apparently did not consider giving such a speech, and Secretary Paulson could never talk in this way. President Obama seemed, at some moments, close to making things clear—when he talked on Wall Street in September and, most notably, when he launched the Volcker Rules in January. But President Obama has always come up short on the prescriptive part—i.e., what we need to do—and his implementation people still move as if there were lead weights in their shoes.

Without a definitive speech, there is no political reference point, there is no convergence in the debate, and there is not even any clarity regarding what we should be arguing about. Without the right kind of speech, there are just many lobbyists working the corridors and a lot of backroom deals that most people do not understand—by design.

On Thursday, March 11, we finally got the speech. Not—sadly—from the White House, not from anyone in the executive branch, and not even from within the Senate Banking Committee (although Senators Merkley and Levin took a big step today), but rather on the floor of the Senate.

In it, Senator Ted Kaufman (D-DE) delivered a strong blow to the overly powerful and unproductively mighty within our financial sector. He said, according to what is on his website:

1. Excessive deregulation allowed big finance to get out of control from the 1980s—but particularly during and after the 1990s. This led directly to the economic catastrophe in 2007–08.
2. We need to modernize and apply the same general principles that were behind the Glass-Steagall, i.e., separating "boring" but essential commercial banking (running payments, offering deposits-with-insurance, etc.) from "risky" other forms of financial activity.
3. We need size caps on the biggest banks in our financial system, preferably as a percent of GDP.
4. We should tighten capital requirements substantially.
5. And we must regulate derivatives more tightly—on this issue, he likes at least some of the steps being pushed by Gary Gensler at the CFTC.

To be sure, a speech is not legislation. And, as yet, this is just one senator's point of view. But because the administration so completely lost the narrative regarding what happened and why, there is now a free, open, and fair competition to explain what we need to do.

The lobbyists will still prevail on this round. But a big debate around the nature of our financial system is exactly what we need.

People who want to defend finance as-is now need come out of the woodwork. Senator Kaufman has set a very high standard. If you wish to oppose this agenda, speak clearly and in public about why we should not pursue exactly what the senator proposes.

If opponents of reform do not come out and argue the merits of their case, people will reasonably and increasingly infer that Senator Kaufman and his allies are right on all the substance.

Reform is blocked by a perverse combination of bankrupt ideology and deep-pocketed corporate interests. The only way to break through is to bring a lot of sunshine into the true affairs of finance—including by speeches like the one we will hear Thursday.

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

The Volcker Principles Move Closer to Practice March 10, 2010

Senators Merkley and Levin, with support from colleagues, are proposing legislation that would apply Paul Volcker's financial reform principles—actually, much more effectively than would the Treasury's specific proposals. (Link to the bill's text.)

Volcker's original idea, as you may recall, is that financial institutions with government guarantees (implicit or explicit) should not be allowed to engage in reckless risk taking. At least in part, that risk taking takes the form of big banks committing their own capital in various kinds of gambles—whether or not they call this proprietary trading.

At the Senate Banking Committee hearing on this issue in early February, John Reed—former head of Citi—was adamant that a restriction on proprietary trading not only made sense, but was also long overdue. Gerald Corrigan of Goldman Sachs and Barry Zubrow of JP Morgan Chase expressed strong opposition, which suggests that Paul Volcker is on to something.

Of course, Goldman—among others—may seek to turn in its (recently acquired) banking license and go back to being "just an investment bank" not subject to Fed regulation. But raising this possibility is a feature, not a bug of the Volcker-Merkley-Levin approach.

Think through this logic—which I argued out with a very senior ex-Goldman person this weekend.

1. If Goldman wants to be saved in the future, it needs to be subject to tough regulation—including this new restriction on proprietary trading.
2. If it doesn't want to be saved, that works for me. But there is no way that Goldman at its current scale—or anything near—could fail without causing enormous collateral damage (literally). Remember that there is no prospect of a "resolution authority" that will work for cross-border financial institutions like Goldman (in private, top officials and leading bankers are willing to concede this).
3. So if Goldman wants to escape the Volcker Rule, it will have to become much smaller.
4. How small is open to discussion—but I would guess that this would be no larger than Goldman's size in 1998 (around $270 billion in today's dollars). Given what we've learned about the limitations of everyone's internal risk models, a sensible regulator would probably want to be even more conservative on size.
5. My assessment is that if Goldman were around $100 billion in total assets, that would be a reasonable outcome—although we still have to worry about what they (or anyone) do in the "dark markets" of over-the-counter derivatives.

In any case, putting these issues openly on the table for Senate Banking—and on the floor of the entire Senate—is incredibly helpful. The Volcker-Merkley-Levin proposal is concrete and feasible, and a useful part of how we can move forward.

Hank Paulson's Memoir: the Inside Job March 10, 2010

If you've read, are reading, or plan to read Andrew Ross Sorkin's Too Big To Fail, you also need to pick up a copy of Hank Paulson's memoir, On The Brink. Sorkin has the bankers' story, in sordid yet compelling detail, of how they received the most generous bailout in the world's financial history during fall 2008—and set us up for great problems to come. Paulson tells us why, when, and how exactly he let them get away with this.

Hank Paulson does not, of course, intend to be candid. As I review in detail on The New Republic's The Book site this morning, On The Brink is actually a masterpiece of misdirection and disinformation.

But still, he gives it all away—and if any details remain obscure, check them in Sorkin. Paulson honestly believes that the financial sector as constructed is productive, makes sense, and should continue to operate in roughly its current form.

Whether or not Paulson really understands the functioning of big banks in the United States today is an interesting question—for example he never mentions how they treated customers during the boom, and there is not one word about the need for greater consumer protection moving forward. On the other hand, perhaps this omission tells us that he understands the game all too well—and is keen for it to continue.

He certainly did his best to make that happen.

Way too Big to Save March 9, 2010

Listening to US officials, talking to legal experts, and waiting for an intense Senate debate on financial reform to begin, you can easily form the impression that "too big to fail" adequately describes our most serious future systemic banking problems. It does not.

In September 2008, the large banks and quasi-banks at the heart of our financial system faced failure—and they were saved in the most immediate sense through actions taken by the Federal Reserve, but the Troubled Asset Relief Program (TARP—passed by Congress and run Treasury) also played a significant supporting role.

The Bush administration threw a small fiscal stimulus into the mix in early 2008, hoping to stave off recession; the Obama administration committed a much larger package at the start of 2009, aiming to prevent anything like a Second Great Depression. This fiscal policy response was in direct reaction to problems caused by the overextension and near failure of the financial system.

Do not make the mistake—for example of Secretary Geithner, talking to the New Yorker—of thinking (or implying) that "saving the financial system" did not involve spending a lot of taxpayer money to support the real economy. Remember that if the economy crashes, asset prices fall, and banks' problems become even more severe.

And try to avoid three further mistakes that are currently common.

1. "Because the government will lose little on its TARP capital injections into banks, the financial rescue ends up not being costly." The true fiscal cost arising from our recent financial excesses is the increase in net government debt held by the private sector. This will likely amount to around 40 percentage points of GDP (i.e., relative to what the Congressional Budget Office's baseline would have been otherwise). That's a huge fiscal cost.
2. "Deficits don't matter." Eventually deficits matter—the fiscal costs incurred in saving our financial system mean higher taxes, relative to what would otherwise have been the case, for you and your children. This is not a call for precipitate fiscal austerity; that would be a disaster. But eventually we will get our fiscal house in order—and then don't pretend to know for whom the tax bell tolls; it doesn't tinkle for Hank Paulson.
3. "We can save our financial system in the future, if we have the right tools—in the form of an appropriately designed resolution authority."
   
   • Such an authority is impossible to achieve, because it would require cooperation between governments (known as a cross-border resolution authority) and that is impossible. (If you don't know why, here's the explanation.)
   • Even if you had an authority that worked, e.g., for purely domestic financial entities, it is a leap of faith to assume it would not be compromised by our political process (again, more background explanation here).

Let's take that leap of faith and say we use the favorite scheme of Gerald Corrigan from Goldman Sachs—he is widely promoting conservatorship as a transition to wind down for large complex financial institutions—and let's say that it "works." Presumably this would mean something like the situation with AIG since September 2008, run somewhat more effectively—perhaps without the obnoxious bonuses. But would that really lower the fiscal costs of stabilizing the economy in the face of a major financial shock? And could we afford those fiscal costs?

Maybe. But the experience in Europe is definitely not encouraging. The Irish state is in serious trouble because major banks failed and were "saved"; let's not even talk about Iceland (where banks' assets peaked around 11 to 13 times bigger than GDP, i.e., the size of the entire economy). And Switzerland faces serious risks—with banks that had peak assets over 8 times GDP—that the international community apparently just wants to ignore (perhaps because Switzerland is not in the G-20 or the even the European Union).

In the United Kingdom, one bank (the Royal Bank of Scotland [RBS]) had assets that were more than GDP (1.25 times, by some estimates). Ask yourself this: if Citigroup, which was around $2.5 trillion before the crisis (including the off–balance sheet commitments, let's call that just under 20 percent of GDP) had actually been $5 trillion, would our problems now be larger or smaller? What if Citigroup—or whoever becomes our biggest bank—reaches $10 trillion or $15 trillion in today's dollars and then fails, how would you feel about that?

The administration proposes—in one part of the Volcker Rules—to cap the size of individual banks relative to total nominal liabilities of the financial system. That makes no sense at all—go talk to the Irish, the British, the Swiss, or the Icelanders (when they become less furious and are willing to talk).

Big banks have a funding advantage—the implicit government guarantee makes it easier for them to raise capital and cheaper for them to borrow money. They will become larger. There are no economies of scale in banking above $100 billion in total assets, but this is not about economics. It's the politics of becoming large in order to become even bigger—building your empire, and paying yourself and your people a lot more money (in the good times) and making it more likely your fiefdom survives (in bad times).

The biggest banks in some European countries today are already too big to save. Unless we take immediate and real action to reduce the power—and size—of our largest banks, we are heading in exactly the same direction.

Is the Senate finally ready to address this issue?

They Saved the Big Banks but Kind Of Lost the Economy Doing It March 8, 2010

It would be easy to take relatively cheap shots at the portrayal of Tim Geithner—"we saved the economy but kind of lost the public doing it"—in the New Yorker, out today.

1. Mr. Geithner is quoted as saying, "Some on the left have fallen into a trap set by the Republicans, allowing voters to mistakenly think that the biggest part of the bank bailout had come under Obama rather Bush." Mr. Geithner should know—as he spearheaded the saving of banks and other financial institutions under both Bush and Obama. In fact, it's the continuation of George Bush's policies by other means that really has erstwhile Obama supporters upset.
2. "I think there are some in the Democratic Party that think Tim and Larry are too conservative for them and that the president is too receptive to our advice." Probably this is linked to the fact that Tim Geithner is not a Democrat.
3. Geithner also suggests that his critics compare government spending on different kinds of programs under President Obama: "By any measure, the Main Street stuff dwarfs the Wall Street stuff." This insults our intelligence. Wall Street created a massive crisis and we consequently lost 8 million jobs; any responsible government would have tried hard to offset this level of damage with all available means. This includes fiscal measures that will end up increasing out privately held government debt, as a percent of GDP, by around 40 percentage points. It's not the fiscal stimulus, broadly defined, that is Mr. Geithner's problem—it's the lack of accountability for the bankers and politicians who got us into this mess.

But the Geithner issues reflected here run much deeper. The New Yorker's John Cassidy alludes to these but he may be too subtle. Here's the less subtle version.

What exactly was the "Geithner stabilization plan" that frames the article—and is the basis for Secretary Geithner claiming to have saved anything? We are not really talking about the much vaunted but little used toxic asset/loan purchase program (the Public-Private Investment Program [PPIP]). "The plan" here means essentially the stress tests designed by Treasury and run by the Fed—which brought some transparency to banks' balance sheets, but which also used a relatively benign "stress scenario" (watch commercial real estate, residential mortgages, and credit card losses now unfold).

The main feature of the plan, of course, was—following the stress tests—to communicate effectively that there was a government guarantee behind every major bank or quasi-bank in the United States. Of course this works in the short-term—investors like such guarantees. But there's a good reason we usually don't guarantee all financial institutions—or act happy when other countries do the same. Unconditional bailouts lead to trouble, encouraging reckless risk taking and undermining responsible governance. You can't run any form of reasonable market system when some big players hold "get out of bankruptcy free" cards.

All crises end—this is actually Larry Summers's famous line. We avoided a Great Depression primarily because, compared with 1929–31, we have a government sector that is large relative to the economy—and that does not collapse when credit goes into freefall. What exactly did the Obama administration do in ending the crisis that a Clinton or McCain administration—or even Bush—would not have done? The most plausible answer is: Nothing.

Geithner insists, according to John Cassidy, that the Obama administration has "proposed the biggest regulatory overhaul in seventy-five years." This is the worst conceit. The sad and unfortunate truth is quite the opposite—because Mr. Geithner and his colleagues refused to seize the moment and didn't break the economic and political power of anyone who mattered, they have doomed us to rerun the same horrible credit loop as before. Legislation may tweak the details, but the regulation and control of systemic risk remains just as weak as before.

Is the Secretary of the Treasury completely unaware that our biggest banks have become even bigger? Why does he send out Herb Allison, long-time Merrill Lynch executive and now an assistant secretary, to say the US government has "no too big to fail bailout policy" when this is patently not true? Why has he reshaped the details of the Volcker Rules so they are now meaningless?

In truth, "too big to fail" is not the worst thing we should fear—our financial institutions are now on their way to becoming "too big to save." In 1929–30, even if the federal government had wanted to put in place a big fiscal stimulus, it could only have mounted something around 1 percent of GDP; the financial shock of that day was much bigger. Perhaps monetary policy in the early 1930s could have done more, but today we have already pushed "quantitative easing" (meaning that the Federal Reserve buys junk) beyond recorded limits. How much do you want to gamble that next time the Fed can do enough to save the day without also creating massive collateral damage?

If we continue to allow banks to grow as they have over the last 30 years—and did again through the latest boom-bailout-rescue cycle—we head toward a day when Mr. Geithner or his successor will try to save the financial system and will fail.

You might think that is a good thing and for sure it will bring on a big change in creditor attitudes and presumably much stronger regulation. But just as in the 1930s, first we will have to dig out from under a lot of economic rubble—and we'll lose a lot more than 8 million jobs.

European Monetary Fund Arriving Soon March 8, 2010

American officials are annoyed and deeply skeptical—not thinking that this will amount to anything. But the future has finally arrived—or perhaps its arrival has just been announced—in the form of the European Monetary Fund.

Such an institution would represent a major reshaping of global financial architecture, undermining the traditional basis of power for the United States—which would prefer to keep the International Monetary Fund (IMF) paramount. This is a good thing for the world, but also for the IMF and—believe it or not—for the United States.

I laid out the case for regional Monetary Funds in BusinessWeek last year. The main point is that it makes sense to have a two-tier system—at the regional level (or for countries grouped in some other way, like "emerging markets") and at the global level, meaning the IMF.

The regional entities would be like your family doctor; the IMF runs the big hospital. If you go in with chest pains, your friendly physician will try to get you to change your diet, exercise more—and may also provide some relatively harmless pills. If you have a heart attack, however, you need to go to the emergency room—where their bedside manner may be less than ideal, but they can actually save your life.

How much capital would the EMF need in order to be credible? We're obviously at an early stage, but as a first pass I suggest 250 billion euros in "cash equivalents" as capital and another 500 billion euros in the form of credit lines.

Will the EMF include only euro countries or cover the whole European Union? This probably depends on how involved France and Germany would like to be with Britain's problems. My guess is that they'll stay away, at least initially—so the "euro members only" sign will go up.

And, of course, there will be a lot of huffing and puffing on the European stage before the deal gets done. But they'll get the EMF done, probably sooner than you think.