Simon Johnson's Blog, page 48

The Huntsman Alternative

By Simon Johnson

The eurozone financial situation continues to worsen.  The latest idea from the eurogroup of finance ministers is apparently to have the European Central Bank make a massive loan to the International Monetary Fund, which would then turn around and lend to countries like Italy.  This is a bizarre notion.  If the IMF takes the credit risk of a mega-loan to Italy – e.g., an amount around the $600 billion mark, greater than the fund's current lending capacity – this would represent an unprecedented and unacceptable risk to the IMF's shareholders, including U.S. taxpayers.  If the IMF does not take this credit risk, what's the point?  The ECB should provide financial support directly to Italy, if that is the goal.

But that goal increasingly seems both to be the only idea of officials and the last failed notion of a fading era.  More bailouts and the reinforcement of moral hazard – protecting bankers and other creditors against the downside of their mistakes – is the last thing that the world's financial system needs.   Yet this is also the main idea of the Obama administration.  Treasury Secretary Tim Geithner told the Fiscal Times this week that European leaders "are going to have to move more quickly to put in place a strong firewall to help protect countries that are undertaking reforms," meaning more bailouts.  And this week we learned more about the underhand and undemocratic ways in which the Federal Reserve saved big banks last time around.  (You should read Ron Suskind's book, Confidence Men: Wall Street, Washington, and the Education of a President, to understand Mr. Geithner's philosophy of unconditional bailouts; remember that he was president of the New York Fed before become treasury secretary.)

Is there really no alternative to pouring good money after bad?

In a policy statement released this week, Governor Jon Huntsman articulates a coherent alternative approach to the financial sector, which begins with a diagnosis of our current problem: Too Big To Fail banks,

"To protect taxpayers from future bailouts and stabilize America's economic foundation, Jon Huntsman will end too-big-to-fail. Today we can already begin to see the outlines of the next financial crisis and bailouts. More than three years after the crisis and the accompanying bailouts, the six largest U.S. financial institutions are significantly bigger than they were before the crisis, having been encouraged by regulators to snap up Bear Stearns and other competitors at bargain prices"

Mr. Geithner feared the collapse of big banks in 2008-09 – but his policies have made them bigger.  This makes no sense.  Every opportunity should be taken to make the megabanks smaller and there are plenty of tools available, including hard size caps and a punitive tax on excessive size and leverage (with any proceeds from this tax being used to reduce the tax burden on the nonfinancial sector, which will otherwise be crushed by the big banks' continued dangerous behavior).

The goal is simple, as Mr. Huntsman said in his recent Wall Street Journal opinion piece: make the banks small enough and simple enough to fail, "Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality."

The path we are on leads to more state ownership of banks in Europe – not a good idea – and, in the United States, huge open-ended subsidies to private banks.  Executives in those banks get the upside and American taxpayers and workers get the downside – a huge recession, damage to millions of lives, and a huge run-up in government debt due to lost tax revenue.

Everything else Mr. Huntsman wants is also eminently sensible, including full transparency in the derivatives market.  Who will argue with that proposal as we watch the European financial sector spiral downwards – driven partly by the fear of what lurks in prominent opaque transactions and balance sheets?

Mr. Huntsman has also spotted the fatal flaw in Basel III: "The Basel III Accord primes the pump for the next financial crisis by putting its thumb on the scale of sovereign debt, making it less expensive for banks to invest in those instruments without making a realistic risk assessment."  Again, in the light of recent developments in Europe, who can seriously dispute this?

These are not fringe or unproven ideas.  When I talk with sensible people in and around the financial sector, these are exactly their views.  These are also natural Republican ideas – what we have now is not a market, it's a huge, unfair, and dangerous subsidy scheme.  Such points are made by top academics like Gene Fama (University of Chicago) and Alan Meltzer (Carnegie Mellon), former officials such as Nicolas Brady and George Schultz (both former treasury secretaries), as well as by top Federal Reserve officials, like Richard Fisher (president of the Dallas Fed) and Tom Hoenig (recently retired from being president of the Kansas City Fed; nominated to become the number two person at the FDIC).  (See my coverage of this strong current of Republican thinking in past Economix columns, including these two.)

Only Teddy Roosevelt could take on the industrial and railroad monopolies in 1901, only Richard Nixon could go to China in 1972, and only Jon Huntsman can face down the Too Big To Fail banks today.

An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

The End Of The Euro

By Peter Boone and Simon Johnson – this post is the first two paragraphs of a column that appears this morning on Bloomberg.com

Investors sent Europe's politicians a painful message last week when Germany had a seriously disappointing government bond auction. It was unable to sell more than a third of the benchmark 10-year bonds it had sought to auction off on Nov. 23, and interest rates on 30-year German debt rose from 2.61 percent to 2.83 percent. The message? Germany is no longer a safe haven.

Since the global financial crisis of 2008, investors have focused on credit risk and rewarded Germany with low interest rates for its perceived frugality. But now markets will focus on currency risk. Inflation will accelerate and the euro may break up in a way that calls into question all euro-denominated obligations. This is the beginning of the end for the euro zone.

To read the rest of this column, please use this link: http://www.bloomberg.com/news/2011-11-28/the-euro-area-is-coming-to-an-end-peter-boone-and-simon-johnson.html

The American Political System . . .

. . . in one cartoon.

1994 vs. 2011

By James Kwak

I'm sorry that I've been too busy for the past two weeks to blog much, but I did manage to write a column for The Atlantic yesterday. It looks at how far the conservative revolution has come in less than a generation and wonders why they can't just declare victory and go home.

Why Not Break-Up Citigroup?

By Simon Johnson

Earlier this week, Richard Fisher – President of the Dallas Federal Reserve Bank – captured the growing political mood with regard to very large banks:  "I believe that too-big-to-fail banks are too-dangerous-to-permit." Market-forces don't work with the biggest banks at their current sizes; they have great political power and receive almost unlimited implicit subsidies in the form of protection against downside risks – particularly in situations like now, with the European financial situation looking precarious.

"Downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy."

Mr. Fisher is an experienced public official – and also someone with a great deal of experience in financial markets, including running his own funds-management firm.  I increasingly meet leading figures in the financial sector who share Mr. Fisher's views, at least in private.

What then is the case in favor of keeping mega-banks at their current scale?  Vague claims are sometimes made, but there is very little hard evidence and often a lack of candor on that side of the argument.  So it is refreshing to see Vikram Pandit, CEO of Citigroup, go on the record with The Banker magazine to at least explain how his bank will generate shareholder value.  (The interview is behind a paywall, unfortunately).

Citi is one of the world's largest banks.  According to The Banker database, which uses data from the end of 2010, it had total assets of just under $2 trillion – putting it in the top ten worldwide.  Overall, The Banker ranks it as number four in its "Top 1000 World Ranking".  Citi is also #39 on the Forbes top 500 global companies list, with total employment of 260,000.

Is there indication in Mr. Pandit's vision that mega-banking will be good for the rest of us in the future?  Don't look for Citi to drive any kind of rethinking for the US consumer market – Mr. Pandit wants out: "We made a similar decision that we were too large in the US consumer finance business and to downsize."

The engines of growth, according to Mr. Pandit, will be "the global transactions services business" and "emerging markets."

Transaction services are important but they do not require a very large balance sheet – these can equally well be performed by a network of small, nimble financial firms.  Global commerce existed for centuries before banks built up risks that are large relative to their home economies.

And emerging markets are risky – Mr. Pandit is essentially betting that Citi can ride the cycle in those countries.  Probably there will be relatively good profits for a number of years and this will justify high compensation levels.  But when the cycle turns against emerging markets – as it did in 1982 – what happens?

In 1982, Citi had a large loan exposure to the emerging markets of the day, Latin America, communist Poland and communist Romania; it was saved from insolvency by "regulatory forbearance," meaning that the Federal Reserve and other regulators did not force them to recognize their losses.  Citi was a relatively big bank at that time – but it was much smaller than it is today.

And its complex global operations are exactly what would make it very hard to "resolve" or put through orderly liquidation under Dodd-Frank.  I argued here in March that there is no meaningful resolution authority for global banks; before and after that column I've taken this point up in private with senior officials in the US and Europe responsible for handling the potential failure of such entities.  No one disagrees with my main point – we cannot handle the collapse of a bank like Citigroup in "orderly" fashion.

Jon Huntsman put megabanks on the agenda for the Republican primaries, with a blistering op ed in the Wall Street Journal a few weeks ago: Too Big to Fail is Simply Too Big.

Other contenders for the Republican nomination have followed his lead, including most recently Newt Gingrich.  Whoever ends up going head-to-head with Mitt Romney is likely to make good use of this very theme – because Mr. Romney already has so much financial support from the top of Wall Street, it will be very hard for him to respond effectively.

Breaking-up the biggest banks is not a fringe idea to be brushed off; Mr. Fisher is speaking for many people who work in financial services – the big banks are not good for the rest of us.  Mr. Pandit's interview just reinforces this point.

Any Republican candidate who claims to be fiscally responsible must eventually confront the issue – what was the role of big banks in the enormous recession and consequent massive loss of tax revenue since 2008?  Which sector poses clear and immediate danger to our fiscal accounts, looking forward – and in a way that is not yet scored properly in any budget assessment?  As Mr. Fisher put it, rather graphically,

"Perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of these banks and downsize them to manageable proportions."

I suggest that Mr. Fisher could reasonably begin with Citigroup.

An edited version of this post appeared on the NYT.com's Economix blog this morning; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Wall Street v. Elizabeth Warren

By Simon Johnson

Karl Rove's Crossroads GPS group has launched the first attack ad against Elizabeth Warren, presumably because she is now running hard for the Senate in Massachusetts.  This ad is not a big surprise, but the line that Mr. Rove takes could well backfire.

The ad states, "we need jobs, not radical theories and protests," so we can break the argument down into three separate parts.

First, who destroyed more than 8 million jobs in the United States – and plunged us into the deepest and longest lasting recession since the 1930s?  Surely this was not Ms. Warren, who was just a law school professor, in the run-up to 2008.

Mr. Rove is opening the blame game and this is going to go badly for his presumed supporters – the largest banks on Wall Street that took excessive risks, paid their top people well, and then blew themselves up at great cost to the American taxpayer.  By all means, let us have a conversation about jobs and the history of job losses in the United States; "too big to fail" banks do not look good in this context.

Second, what exactly is the radical theory here?  Ms. Warren's point has been that we regulate the safety of toasters but not financial products.  Basic consumer protection is, of course, still resisted strongly by the less reputable parts of the financial sector.  But honestly, what well-run and honest firm fears sensible product standards, which is exactly what the Consumer Financial Protection Bureau is working on establishing?

Ms. Warren proposed the CFPB and helped oversee its creation and early operation – this is a major contribution to financial stability in the United States.  To be sure, some people in the financial sector feel that their track records are exemplary and perhaps they are right – but who was asleep at which switch when mortgage lending went off the ethical rails?  The financial sector had plenty of opportunity to restrain is more dangerous participants; instead the misbehavior – or worse – was egregious and incredibly damaging to many Americans.

If there was a radical theory, it was the idea that big banks could manage their risks effectively and must be allowed to bulk up on the basis of large amounts of short-term debt funding, underpinned by only thin slivers of equity.  This theory – completely at odds with any sensible reality – is at the heart of the job losses and our current difficulties.

Another radical theory, appearing here implicitly, is that if we let banks make loans now without any oversight, this would somehow give us back jobs.  Again, if Mr. Rove wants to discuss crazy theories, let us have that conversation – perhaps with a topical focus on what is going so badly wrong in Europe, including its mad levels of bank debt.

If powerful people on Wall Street want to have the political fight, we should escalate to the main issue lurking here: Too big to fail is simply too big.  This is a theme around which right, center, and left can all rally.  Hopefully, this is exactly what the broader debate will increasingly focus on.

Third, what do the Occupy Wall Street protesters really want?  According to Mike Konczal's careful assessment of their published grievances, jobs are the number one issue.  So again we should ask: Who caused the financial crisis that destroyed so many jobs?

The biggest financial firms have become even larger since the crisis.  Their ability to take risk is essentially unfettered.  Attempts to roll-back their power have largely been rebuffed.  The European crisis now threatens to overcome some of the largest, precisely because they resisted efforts to make them build up larger buffers against losses (shareholder equity).  How is this conducive to job creation in any sustained manner?

Elizabeth Warren cannot rein in the most dangerous elements of Wall Street by herself.  But she can – and she will – try.  We should expect dangerous parts of the financial sector – relatively small in numbers but with enormous financial resources – to push back with drama, disinformation, and perhaps even deceit.

At the end of the day, the voters of Massachusetts will decide.  Do they believe in the radical – in fact, ludicrous and manifestly disproven – theory that "too big to fail" banks will generate good jobs for all?  Or do they think that such banks, left to their own devices, will plunge us into another crisis, just as profound as what the Europeans are now going through?

If Mr. Rove directs their attention along these lines, that would be helpful.

Is Europe On The Verge Of Another Great Depression – Or A Great Inflation?

By Simon Johnson

The news from Europe, particularly from within the eurozone, seems all bad.  Interest rates on Italian government debt continue to rise.  Attempts to put together a "rescue package" at the pan-European level repeatedly fall behind events.  And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

In addition, the pessimists argue, because the troubled countries are locked into the euro, there are no good options.  Gentle or even dramatic depreciation of the exchange rate for Greece or Portugal or Italy is not in the cards.  As a result, it is hard to lower real wages so as to restore competitiveness and boost trade.  This means that the debt burdens for these countries are likely to seem insurmountable for a long time.  Hence there will likely be default and resulting global financial chaos.

According to the September 2011 edition of the IMF's Fiscal Monitor, 44.4 percent of Italian general government debt is held by nonresidents, i.e., presumably foreigners (Statistical Table 9).  The equivalent number for Greece is 57.4 percent, while for Portugal it is 60.5 percent.  And if you want to get really negative and think the problems could spread from Italy to France, keep in mind that 62.5 percent of French government debt is held by nonresidents.  If Europe has a serious meltdown of sovereign debt values, there is no way that the problems will be confined just to that continent.

All of this is a serious possibility – and the lack of understanding at top European levels is a serious concern.  No one has listened to the warnings of the past three years.  Almost all the time since the collapse of Lehman Brothers has been wasted, in the sense that nothing was done to put government finances on a more sustainable footing.

But perhaps the pendulum of sentiment has swung too far, for one simple and perhaps not very comfortable reason.

There is no way to have just a little debt restructuring for Italy.  If Italian debt involves serious credit risk – i.e., a nonzero probability of default – then all sovereign debt in Europe will need to be repriced, downwards.  There is a notion that Germany will remain a safe haven, but even that is far from clear.  According to the IMF, gross government debt in Germany will be 82.6 percent of GDP at the end of this year (Statistical Table 7 of the IMF's Fiscal Monitor; the net government debt number for 2011, in Statistical Table 8, is 57.2 percent).  Reports of German fiscal prudence have been greatly exaggerated.

There is no way that the German policymakers or the German public will do well in the event of a major sovereign credit disaster.  Credit would tighten across the board.  German exports would plummet.  The famed German social safety net would come under great pressure.  If Germany had to call in the International Monetary Fund for advice, even informally and behind the scenes, how would that feel?

And they have an alternative – allow the European Central Bank to provide "liquidity" support across the board to the troubled governments.

There are many things wrong with this policy – and it is exactly the kind of moral hazard-reinforcing measure that has brought us to the current overindebted moment.  None of us should be happy that Europe – and the world – has reached this point.

Among others, the bankers who bet big on moral hazard – i.e., massive government-backed bailouts – are about to win again.  Perhaps the Europeans will be tougher on executives, boards, and shareholders than the Obama administration was in early 2009, but most likely all the truly rich and powerful will do very well.

But if your choice is global calamity or – effectively – the printing of money, which would you choose?

The European Central Bank has established a great deal of credibility with regard to keeping inflation at or close to 2 percent.  It could probably offer a great deal of additional support – through creating money – without immediately causing inflation.  And if the ECB is providing a complete backstop to Italian government debt, the panic phase would be over.

None of this is a lasting solution, of course.  Europe needs a proper fiscal center – much as the United States needed in 1787 and got under Alexander Hamilton's policies from 1789.  Hamilton remains a controversial figure in US history but when he took over the US was in default and the credit system was almost completely broken.  Some centralized tax revenue and control over fiscal deficits

Mr. Berlusconi stood in the way of all this.  There is no way that the other Europeans would trust him to tighten Italian fiscal policy.  But if he is really gone from power – and we should believe that only when we see it – there is now time and space for Italy to stabilize and, with the right help, find its way back to growth.

Of course, if the ECB provides unconditional financial support to Italian or other politicians who refuse to bring their deficits under control, then we are heading for another Great Inflation.

An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Our Health Care System, Compared

By James Kwak

I was looking at OECD health care data for something else I've been working on and wanted to share some of it. It's well known that the United States spends a lot more per person on health care than comparable countries and that our actual health outcomes are anywhere from average to bad. See, for example, this chart from a 2008 paper by Gerard Anderson and Bianca Frogner.

That chart shows how each country's spending and life expectancy differ from what you would expect based solely on how rich they are (per capita GDP). As you can see, we spend a lot more and live a lot less. (That paper also considers a number of other outcome measures; we do well on some, poorly on others.)

Besides where we are today, though, the other thing we should be interested in is where we are going. Our health care system is the product of a number of historical factors that we can't make go away with a snap of our fingers. So even if we have a bad, expensive health care system, maybe it is getting relatively better and relatively less expensive.

Nope.

This chart, from the OECD data, shows the change in each country's per capita spending and life expectancy relative to all other countries. The data are standardized: you're looking at the number of standard deviations each country was away from the mean in 1992 and in 2007.*

You can see that not only is the United States the outlier when it comes to spending, but we are moving in the wrong direction: we are becoming more of a spending outlier, and we are drifting down from the average life expectancy into the lower group (currently surpassing only Turkey, Hungary, Mexico, Poland, and Czech Republic).

I labeled a few of the other outliers. Basically the lower left is relatively poor countries, Japan is at the top, and that big cluster is Western Europe and the Commonwealth countries.

Another way to look at the situation is to look at actual values rather than standard deviations, as in the following chart. This one shows you actual increases in life expectancy and percentage increases in nominal per capita health care spending. The axes are located at the averages of these countries: the average spending increase was 132 percent and the average life expectancy gain was 3.7 years.

One thing you can see is that, in percentage terms, health care costs have not been growing in the United States much faster than in other comparable countries.** If you exclude countries starting with a small 1992 base (Korea, Turkey, Ireland, etc.), our rate of health care cost growth has been above average, but it's not an outlier. So the reasons why our health care costs are growing rapidly are probably at least somewhat different from the reasons why they are high to begin with.

The other thing you see is that our life expectancy gain was the absolute lowest of the whole group (and we weren't starting from a particularly high level, as you can see in the previous chart).

Ordinarily, you would think there should be convergence across countries. Since other countries spend less and live longer, you would think that we would learn from them—global competition, you know. But instead we're moving the wrong way on both dimensions.

* I picked all OECD countries for which there was data, except Belgium (which has a different methodology for counting spending), which meant dropping Chile, Estonia, Israel, Luxembourg, Slovak Republic, and Slovenia. I only went back to 1992 because Germany has a gap in 1991 and I initially planned to use all the intervening years. I stopped in 2007 because Canada and Greece are missing data for later years.

** We had below-average growth in percentage terms, yet the number of standard deviations separating us from the mean increased, because the poorer countries increased spending rapidly; this convergence caused the standard deviation to fall as a proportion of the mean.

What Could the US Achieve at the G20 in Cannes?

By Simon Johnson

The April 2009 London summit of the G20 is widely regarded as having been a great success.  The world's largest economies agreed on an immediate coordinated approach to the global financial crisis then raging and promised to work together on banking reforms that would support growth.  At the time, President Obama got high marks for his constructive engagement.

The G20 heads of government have met twice a year since London and in Cannes this week they meet again (November 3-4).  Could this summit also help stabilize the world economy?  And can President Obama again play a leading role?  The answer to both questions is likely the same: No.

In 2009, the primary problem was slumping economies in the United States and Western Europe.  It was in the perceived individual interest of those economies to engage in some fiscal stimulus – and they were happy to present this as a joint approach.  China was also willing to stimulate its economy, as its policymakers feared slowing global trade would lower Chinese exports.  President Obama's appeal for fiscal stimulus around the world was pushing on an open door.

Now the issue is quite different.  We have a sovereign debt crisis within the eurozone, in which countries that have borrowed heavily are facing the prospect of restructuring their debts.  The eurozone summit last week established that Greek debt will fall by about half (relative to face value), although this does not clearly put Greece onto a sustainable debt path.  The surprise referendum in Greece, announced this week, could build political support for the needed reforms.  Or it could lead Greece to exit the euro and to default on its debts in a "disorderly" manner – meaning without any kind of international framework or outside financial support.

But the real issue is Italy, as it has been at least since the summer. The Europeans are only beginning to get to grips with the centrality of Italy in the European debt web – glance at Bill Marsh's recent graphic to get the point.  Italy has over 1.9 trillion euros in debt outstanding; this is the third largest bond market in the world.  In the aftermath of the Greek referendum announcement, the yield on Italian debt rose above 6.1 percent – the standard view is that if this reaches 6.5 percent, Italy will need to seek assistance in the form of a back-stop fund, to guarantee that there will be no default.

But the International Monetary Fund does not have enough resources available and the existing European Financial Stability Facility is also likely too small.  Informed observers talk of the need for more than 2 trillion euros in a "stabilization fund" and while there is a lot of fuzzy math involved in contemporary international financial rescues, the IMF and EFSF combined would be hard pressed to provide more than a third of that.

This might seem like a good time for a summit – so the hat can be passed around world leaders.  And some people do hope that China could provide an enormous loan, either directly or working with the IMF.  China, after all, has more than 2 trillion euros worth of reserves (not all in euros, of course; much of this is in dollars).

But it's not clear China wants to take the credit risk of lending directly – the Europeans might not pay back, after all.  And the US is not keen to have China funnel such a large amount through the IMF; this would undermine the traditional US predominance there.  In today's budgetary environment, there is no way that the US can come up with anything like matching funding at a level that would make a difference – would you like to ask the House of Representatives for $100 billion right now, to help keep Mr. Berlusconi in power?

And the heart of the problem is really European, not global.  Specifically, the eurozone needs to address its underlying fiscal structure, which has become severely dysfunctional.  They need a proper fiscal union, with the right to tax and to issue debt – backed ultimately by the European Central Bank.  And the ability of member governments to issue new debt must be severely curtailed.

The US faced a similar problem, long ago.  The original Articles of Confederation proved inadequate, largely because there was no centralized fiscal authority.  The Constitutional Convention convened in 1787 in large part because the US had defaulted on its debts – incurred during the war of independence – and there was no way forward without a new agreement among the original 13 states and greater fiscal powers (and more) for the federal government.

Europe needs the equivalent of a constitutional convention.  But today's financial markets move so much faster than 200 years ago and the delay to date in Europe has already been excessive.  The Europeans need to move fast.  Will the Cannes summit speed them up?

An edited version of this post appeared on the NYT.com Economix blog today; it is used here with permission. If you would like to reproduce the entire post, please contact New York Times.

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Who Wants Tax Cuts?

By James Kwak

Yesterday I wrote an Atlantic column about Republican presidential candidates' fondness for tax plans that transfer massive amounts of money from the poor to the rich. The main question, to my mind, is why people like Herman Cain and Rick Perry talk about transferring massive amounts of money to the rich when polls show that even a majority of Republicans think the rich should pay more in taxes.

Many of the readers here could probably  have written that column themselves, but it does have a wonderful picture of Cain and Perry in all their well-dressed glory.

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