On Friday, Senator Bob Corker (R, TN) took to the Senate floor to rebut critics of big banks.  His language was not entirely senatorial: “I hope we’ll all come to our senses”, while listing the reasons we need big banks.  And Senator Chris Dodd (D, CT) rose to agree that (in Corker’s words) reducing the size of our largest banks would be “cutting our nose off to spite our face” and that by taking on Wall Street, “we may be taking on the heartland.”

Unfortunately, all of their arguments in favor of our largest banks remaining at or near (or above) their current scale are completely at odds with the facts (e.g., as documented in our book, 13 Bankers).

The senators led with the idea that our nonfinancial sector needs huge, complex, global banks in order to remain competitive internationally.  But this is completely untrue – in fact, Senator Dodd conceded as much to Ezra Klein recently when he said that he had heard the arguments of 13 Bankers against big banks also from “CEOs” (presumably of nonfinancial companies).

Even the biggest nonfinancial companies do not, under any circumstances, want to buy all their financial services from one megabank.  They like to spread the business around, to use different banks that are good at different things in different places – in part to prevent any one bank from having a hold over them.  Playing your suppliers off against each other to some degree is always a good idea.

Senator Corker also argued that entrepreneurs need today’s megabanks.  Please find me a single entrepreneur who would agree with that statement – keeping in mind that I work with a lot of entrepreneurs in my day job (professor of entrepreneurship, among other things, at MIT, with a particular focus on entrepreneurs working globally).  Of course entrepreneurs need access to capital and they need investors who are willing to back risk-takers in the nonfinancial sector, but if you can find a link between that productive activity and what Goldman Sachs is accused of doing by the SEC, write it up.

Senator Corker also stressed that businesses need to be able to hedge risks, e.g., regarding their input prices.  This is a fair point but it is completely unrelated to how large our biggest banks should be.  This is instead an argument for allowing the existence of derivatives market – like Gary Gensler of the CFTC, we take the view that requiring all derivatives to be traded on exchanges would not only reduce system risk, it would also be completely consistent with all legitimate and productive derivative-related transactions, and it would reduce the size of the largest broker-dealers (who currently have a great deal of market power when so much of derivatives trading is over-the-counter).

Both Senator Corker and Senator Dodd stressed that the biggest US banks are not the biggest banks in the world.  But what does that have to do with anything?  The largest European banks are again in seriously trouble this weekend – because they piled on exposure to the eurozone periphery in an irresponsible and frankly dumb manner.  The largest Chinese banks are a complete mess in terms of governance and ability to make a sensible loan.  And the biggest Canadian banks are underwritten by government guarantees of a nature and scale that make Fannie Mae and Freddie Mac look respectable during the go-go years (which they were not) – we have taken these points up at the highest levels within the Bank of Canada and they get this.  So why would anyone think that any of these global banks is an appealing model for the United States to follow?

Senator Corker is opposed to any “arbitrary limit” on bank size.  Senator Dodd’s support for Senator Corker on Friday is striking and surprising because, at least nominally, the Dodd financial reform bill as it came out of committee does cap bank size – see Section 620, “Concentration Limits on Large Financial Firms”:

“Subject to recommendations from the Financial Stability Oversight Council, a financial company may not merge or consolidate with, acquire all or substantially all of the assets of, or otherwise acquire control of, another company, if the total consolidated liabilities of the acquiring financial company upon consummation of the transaction would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the calendar year preceding the transaction.  The Council recommendations will be included in a study of the extent to which the concentration limit under section 620 would affect financial stability, moral hazard in the financial system, the efficiency and competitiveness of United States financial firms and financial markets, and the cost and availability of credit and other financial services to households and businesses in the United States. The intent is to have the Council determine how to effectively implement the concentration limit, and not whether to do so.  The Council will have six months to write the study, and the Board of Governors of the Federal Reserve will have nine months in which to issue regulations that reflect the recommendations and modifications of the Council.

This is obviously very weak, in part because at best it only applies to acquisitions. This is a significant watering down of the Second Volcker Rule, which read in January:

“2. Limit the Size- The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.”

Unfortunately, for whatever reason, the White House appears to have completely folded on the substance.  Larry Summers now claims (inaccurately) “most observers” think breaking up big banks would be a bad idea because, 

“Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies, and hurt the competitiveness of the United States.”

“But that’s not the important issue, they believe that it would actually make us less stable. Because the individual banks would be less diversified, and therefore at greater risk of failing because they wouldn’t have profits in one area to turn to when a different area got in trouble.

“And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”

The Brown-Kaufman SAFE banking act would cap banks, as a practical matter, between about $100 billion and $450 billion in total assets – depending on their exact risk profile.  What exactly is the diversification that you can do at $2 trillion that cannot be done at $100 billion?

The Corker-Dodd-Summers view follows closely the line from Hal Scott, a Harvard law school professor (and a director of Lazard) who strongly favors the big banks  – for example, he testified against any form of the Volcker Rules when we both appeared before the Senate Banking Committee in February.  Scott runs the Committee on Capital Markets Regulation, which recently stated,

“As with the Volcker Rules, the Committee does not believe that size limitations will reduce systemic risk. An institution does not pose systemic risk because of its absolute size, but rather because of its debt, its derivatives positions, and the scope and complexity of its other financial relationships. Because the problem is not size but interconnectedness, reform should focus on reducing the interconnections so that firms can fail safely. Furthermore, even if size were the right issue, the Senate Banking bill would not require any existing bank to shrink; it would only prevent further growth by consolidation or acquisition. Assuming size is the source of systemic risk, we should presumably be concerned about it whether it is the result of acquisition or organic growth.”

Of course the issue is about system risk.  Risk is about many things, including the ability of banks (at any size) to circumvent regulation.  But risk is also partly a function of bank size – smaller banks are not too big to fail and this affects the incentives of management and directors (as well as traders, depending on the compensation system).

And if you don’t think our largest banks have completely captured the hearts and minds of their regulators – both prior to September 2008 and perhaps even more subsequently – read 13 Bankers and tell us where we got that part of the story wrong.

If you still really don’t want to cap bank size, take a long hard look at the UK, where RBS had a balance sheet of roughly 1.5 times the UK economy when it failed.  When it failed in fall 2008, Citigroup had total liabilities around $2.5 trillion.  Would our problems now be better or worse if Citi had had $5 trillion in assets – or if it had been the size of RBS relative to the UK economy, i.e., roughly $20 trillion?

As for why exactly Senators Corker and Dodd really support big banks, it seems increasingly likely that this is all about campaign contributions.

What is the basis for major policy decisions in the United States?  Is it years of careful study, using the concentration of knowledge and expertise for which this country is known and respected around the world?  Or is it some unfounded assertions, backed by no data at all?

At least in terms of the White House policy towards megabanks, it is currently “no discussion of data or facts, please”.

Speaking on the Lehrer NewsHour last week, Larry Summers said, with regard to the Brown-Kaufman SAFE banking act – which would restrict the size of our largest banks (putting them back to where they were a decade or so ago):

“Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies, and hurt the competitiveness of the United States.”

“But that’s not the important issue, they believe that it would actually make us less stable. Because the individual banks would be less diversified, and therefore at greater risk of failing because they wouldn’t have profits in one area to turn to when a different area got in trouble.

“And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”

I’ve looked into these claims carefully and really cannot find any hard evidence supporting Summers’s position – and therefore US policy.  To be sure, there have been assertions made along these lines by a few people.

But can the White House point to any published material or even publicly available analysis or data that is relevant to the questions at hand?  How about work that has been presented to critical audiences, preferably with the entire discussion on the public record.  I would be happy to be corrected on this – call me – but I can find nothing.

This is not about jumping through any kind of academic hoops – it is simply a question of whether this critical aspect of our public life is post-Enlightenment (i.e., we worry about the evidence) or stuck at the level of unfounded medieval assertion.

On the other side of the argument, I would submit the evidence reviewed in our book 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown, which – among other things – surveys the available literature, from both academics and practitioners.  Read it for yourself – we wrote it for this moment and this issue.  (Or ignore the book if you prefer; this would put you in good company at the top rungs of our society.)

“Most observers” agree with 13 Bankers on the need to reign in (and constrain the size of) our largest banks.  We’ve presented this book and its findings to top lawyers, finance people, both more academic and completely practitioner.  We’ve talked about it at length on Capitol Hill and with very experienced people who work or have worked throughout the financial system.  We have also argued in detail with anyone who is close to the big banks – although, unfortunately, top executives and their representatives will not come out to debate in the open.  The experts are overwhelmingly on board – except for those who work for the big banks.

I would not have a problem with the administration’s top officials saying, “we can’t take on the biggest banks because (a) they are too powerful in general, and (b) they would cut us off from the campaign contributions that we need for November.”  This would at least be honest – and then we could discuss whether it makes sense as political tactics.

And if the most senior and experienced economic policymakers in the land wish to make their own assertions, unencumbered by the facts, then you can take a view regarding whether or not they have earned the right to be taken seriously.  (By the way, “most observers” think we are very fair to Larry Summers in 13 Bankers; a significant minority think we are overly generous.)

But for the White House to make inaccurate claims regarding the views of “most observers” is the most obvious and cheapest sham. 

Come out and have the discussion on its merits in public.  Or just cut off debate in the Senate, through some sleazy backroom deal, and face the consequences.

The Huffington Post Books section is hosting a discussion of 13 Bankers; there are links to all the posts so far here. Mike Konczal, usually of Rortybomb, weighed in with a post that included this chart:

People from the 90th to the 95th percentile make about 11% of total income; people from the 95th to the 99th percentile make about 15%; and people in the top percentile make about 23% (in 2006, presumably). But mainly, look at the way that black line shoots up relative to the others since 1980 (along with financial sector profits and per-employee banking compensation).

One of Konczal’s points is that one group that is opposed to Wall Street — and supports stronger reform — is people who are doing well, but not nearly as well as the bankers and fund managers in the top 1%. He focuses in particular on certified financial analysts — people who make a lot of money and know how the financial system operates, and are outraged at Wall Street. 68% of them support the Volcker Rule to prevent banks from engaging in proprietary trading. Konczal calls it the “rage of the 1.5% class.”

Michael Lewis, in an interview with Christopher Lydon, said that in his book tour, a lot of his audiences are well-off and moderate well-off professionals — doctors, dentists, lawyers, small business owners, etc. These are people who (at least according to them) followed the rules, worked hard, paid their taxes, made a fair amount of money, etc. — and just saw the economy almost collapse because of what they see as the shenanigans of a tiny, tiny elite that plays by a different set of rules. Lewis or Lydon (I can’t recall which) called it a “revolt of the petty bourgeoisie.” And it is true that one of the societal forces behind the French Revolution was a traditional official class that saw its status threatened by the new capitalist class. (Yes, this is the opposite of what Marx and Engels thought.)

I don’t want to make too much of this. But I think it is true that the pitchfork-wielders of today are not rock-throwing Trotskyites; they are, largely, politically moderate (or conservative) people who believe in capitalism and in making money. And I also think that there has been a relative shift in economic fortunes away from the small business owning class that we like to think of as the bedrock of American society (the modern version of the yeoman farmer of the eighteenth century), and toward a new elite made up of corporate CEOs, investment bankers, and hedge fund managers. Where this will end up I do not know.

There is widespread agreement that the financial crisis which broke out in September 2008 was our most severe in over 50 years.  There is also a consensus that, whatever other factors may have been involved, the excessive risk-taking and general mismanagement of huge banks at the center of our economy played a significant role in what happened.  (Yes, of course the largest banks themselves deny any responsibility – including most recently using insulting language.)

The financial reform package now on the Senate floor puts surprisingly little constraint on the activities of our largest banks going forward – preferring instead to defer to regulators to tweak the rules down the road (despite the fact that this approach has gone badly over the past 20-30 years).

A growing number of senators insist we should do more to reduce the size and limit the leverage of megabanks (i.e., the amount that banks can borrow), arguing that this would constitute an important additional failsafe – on top of all other efforts to establish “more effective regulation”.

Senator Ted Kaufman (D, DE) has led the charge on this issue, pounding away for months – and giving another powerful speech on the floor of the Senate yesterday.

Yet, astonishingly, it seems increasingly likely there will be no real Senate debate on this issue.

A real debate, in the modern American system, needs a vote on something specific – in this case, an amendment to the main legislation.  And Senator Kaufman, with Senator Sherrod Brown (D, OH), to that end has proposed the SAFE Banking Act – with meaningful size and leverage caps – which is ideally suited as a way for senators to show whether or not they support the continued existence of our largest banks in their current (very dangerous) form.

Kaufman has directly taken on and rebutted all the arguments put forward by proponents of big banks – such as Larry Summers of the White House and Hal Scott of Harvard Law School.  Kaufman has the facts and most sensible opinion on his side, including the literature summarized in our book (13 Bankers, which he cited yesterday), and other voices (also quoted in his speech yesterday):

1. Mervyn King, governor of the Bank of England: “Banks who think they can do everything for everyone all over the world are a recipe for concentrating risk.” 
2. Alan Greenspan, formerly chair of the Federal Reserve Board: “For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. A decade ago, citing such evidence, I noted that ‘megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.’ Regrettably, we did little to address the problem.”

With such strong arguments and powerful evidence on its side, you might think that the completely reasonable and responsible proposals in the SAFE Banking Act would get a vote.  But you would be wrong.

The Senate leadership – on both sides of the aisle – has apparently decided that they do not want to give senators (and the public) the opportunity to focus their attention on this key issue.  Instead, they would prefer to keep the “debate”, in terms of votes, on issues less likely to infuriate powerful banks.

Our democracy allows great freedom of discussion – and it is encouraging that someone as prominent as Senator Kaufman can take on (and trounce) the biggest banks on the merits of the case. 

But how much is this freedom worth if the political power of the megabanks – based on campaign contributions, lobbying efforts, and more general ideological control - can effectively prevent an up-or-down vote in the US Senate on the most pressing issue of financial reform?

This is, of course, partly about the political power of corporations.  But corporations are, in this sense, merely a veil – this is really all about which people have what kind of power in our society.  To what extent are we really still a democracy – and how far have we already slipped down the road to oligarchy?

That’s the title of a post a couple weeks ago by Ezra Klein, in which he interviewed a friend of his who went to Wall Street after Harvard. Having seen this phenomenon from a couple of different angles, I’d say the interview is right on. This is how Klein summarizes the central theme:

“The impression of the Ivy-to-Wall Street pipeline is that it’s all about the money. You’re saying that it’s actually more that Wall Street has constructed a very intelligent recruiting program that speaks to the anxieties of the students and makes them an offer that there’s almost no reason to refuse.”

When I graduated from college, I had no interest in investment banking or its close cousin, management consulting. But I went to McKinsey for reasons that were only slightly different than those of the typical Ivy League undergrad; after getting a Ph.D. in history, I discovered that I was unlikely to get a good academic job and was pretty much unqualified for anything else, and McKinsey was one of the few places that would hire me into a “good” job with no discernible qualifications (other than academic pedigree). Now that I’m at Yale Law School, where maybe 15% of students (my wild guess) come in wanting to be corporate lawyers but 75% end up at corporate law firms (first job after law school, not counting clerkships), I’m seeing it again.

The typical Harvard undergraduate is someone who: (a) is very good at school; (b) has been very successful by conventional standards for his entire life; (c) has little or no experience of the “real world” outside of school or school-like settings; (d) feels either the ambition or the duty to have a positive impact on the world (not well defined); and (e) is driven more by fear of not being a success than by a concrete desire to do anything in particular. (Yes, I know this is a stereotype; that’s why I said “typical.”) Their (our) decisions are motivated by two main decision rules: (1) close down as few options as possible; and (2) only do things that increase the possibility of future overachievement. Money is far down the list; at this point in their lives, if you asked them, many of these people would probably say that they only need to be middle or upper-middle class, and assume that they will be.

The recruiting processes of Wall Street firms (and consulting firms, and corporate law firms) exploit these (faulty) decision rules perfectly. The primary selling point of Goldman Sachs or McKinsey is that it leaves open the possibility of future greatness. The main pitch is, “Do this for two years, and afterward you can do anything (like be treasury secretary).” The idea is that you will get some kind of generic business training that equips you to do anything (this in a society that assumes the private sector can do no wrong and the public sector can do no right), and that you will get the resume credentials and connections you need to go on and do whatever you want. And to some extent it’s true, because these names look good on your resume, and very few potential future employers will wonder why you decided to go there. (Whether the training is good for much other than being a banker or a consultant is another question.)

The second selling point is that they make it easy. Yes, there is competition for jobs at these firms. But the process is easy. They come to campus and hold receptions with open bars. They tell you when and how to apply. They provide interview coaching. They have nice people who went to your school bond with you over the recruiting period. If you get an offer, they find out what your other options are and have partners call you to explain that those are great options, but Goldman/McKinsey is better, and you can do that other thing later, anyway. For people who don’t know how to get a job in the open economy, and who have ended each phase of their lives by taking the test to do the most prestigious thing possible in the next phase, all of this comes naturally. (Graduate schools, which also have well-defined recruiting processes, are the other big path to take.) The fact that most companies don’t want new college graduates makes it easier to go to one of the few that do.

The third selling point — not the top one, but it’s there — is the money. Or, more accurately, the lifestyle. The glossy brochures never say how much money you can make. But they make it clear that you will be part of the well-dressed, well-fed, jet-setting elite. When people walk into those offices, with fresh flowers and all-glass walls and free food and modern technology everywhere, they get seduced. Last summer one person wrote to my school’s email list about how wonderful his office was, with its view of Central Park. I mentioned this to an old friend who used to work at McKinsey, and he said, “he fell for the office.*

The same factors are also largely true for top law school graduates, although for them the money is understandably more important. Law school costs close to $200,000 for three years, and I believe the average graduate has about $100,000 in debt. So another major inducement is the idea that you will work at a corporate law firm for three or four years, pay off your debt, and then go work for legal aid or the U.S. attorney’s office.

But the other factors are also very important. If you go to a top law school, it is simply easier to get a corporate firm job than any other job. They all come to campus at the beginning of your second year, most people can get a job simply by following the interview process, you work there for one summer, and then you get an offer to come back. Even if you don’t want to work at a firm, it makes rational sense to do it for that summer to get the offer as Plan B.

By contrast, it’s hard to get a public interest job. Most public interest organizations don’t have the money to hire a lot of people, and many don’t want people right out of law school. So the usual route is you have to apply for a competitive fellowship to work at a public interest organization, and then you have to hope they’ll hire you for good after that year. It’s hard. And that’s how Plan B becomes Plan A. And besides, many prominent corporate lawyers have gone on to important positions in Washington, so there is still the possibility of future greatness.

And once you’re in the door, the seduction begins. As Klein’s interviewee says,

“When people leave law school with a lot of debt, they figure they’ll get some good skills and good money at a top-tier firm before going to save the world. But then you have a great apartment, more responsibilities, kids. You start enjoying it. It’s not even all material.

“And I think it’s important to point out, that things happen very quickly. Private equity firms were trying to recruit us in the first year of my two-year training program. There’s this notion of the accidental banker, people who get caught up in that world and get more and more pay and find it harder to justify leaving. But the cultural effect of all of this — and even with regulatory reform, we need to think about that — is that a lot of people decide to sacrifice much more time than they normally would because the money is so good, and then they believe they deserve extremely high pay because they’re giving up so much time. It’s not malicious. But there are a lot of unhappy people who end up in that situation.”

It’s just human nature. Your expenses grow to match your income. As the decades pass and you realize that no, you’re not going to save the world, the money becomes a more and more important part of the justification. And when you have kids, you’re stuck; it’s much easier to deprive yourself of money (and what it buys) than to deprive your children of money.

More importantly, you internalize the rationalizations for the work you are doing. It’s easier to think that underwriting new debt offerings really is saving the world than to think that you are underwriting new debt offerings, because of the money, instead of saving the world. And this goes for many walks of life. It’s easier for college professors to think that, by training the next generation of young minds (or, even more improbably, writing papers on esoteric subjects), they are changing the world than to think that they are teaching and researching instead of changing the world.

Sure, there are self-parodying, economically delusional, psychotherapy-needing, despicable people on Wall Street, like this one. But there are also a lot of people who went there because it was easy and stayed because they decided they couldn’t afford not to and talked themselves into it.

A college student asked me at a book talk what I thought about undergraduates who go work on Wall Street. And individually, I have nothing against them, although I do think they should do their best to keep their expenses down so they will be able to switch careers later. But as a system, it’s a bad thing that a small handful of highly profitable firms are able to invest those profits into skimming off some of the top students at American universities — universities that, even if nominally private, are partially funded by taxpayer money in the form of research grants and federal subsidies for student loans –and absorbing them into the banking-consulting-lawyering Borg.

* By the way, I think that even within the elite there is an inverse correlation between pay and quality of office; the banks make the most money and have the shabbiest offices, although that has been changing recently.

Update: I want to emphasize, if it isn’t clear from the above, that I don’t claim to be any better than people who do go to Wall Street. I worked at McKinsey, which is more or less the moral equivalent thereof (at least from the perspective of a new entrant to the job market), and for basically the same reasons. And I only left McKinsey because I went to an Internet boom-era software company, and I did that because it seemed even more prestigious and exciting (and potentially more lucrative, although that didn’t work out).

I finally came up with a better way to create a downloadable blog archive (always available via the “Download the Blog in PDF” link under Navigation in the right-hand sidebar). Now the archive is up to date (through April 2010) and you can download it in PDF, Kindle, or EPUB format. And it has clickable bookmarks for each individual post.

Thanks go to Joss Winn, Martin Hawksey, Feedbooks, and Yahoo! Pipes. See the archive page itself for a technical description.

Sometime this morning all of the links from our Facebook page back to the blog stopped working. According to Facebook, “Facebook users” had identified the page as being “abusive.” I didn’t find out until this evening, when a reader emailed me. (I don’t spend a lot of time on Facebook.) When the problem started, it also applied to all of the older links from Facebook to the blog. The problem did not seem to affect links from the Facebook page to 13bankers.com.

Then, in the last half our, the problem went away, and now all the links work.

I have no idea what happened. For background, this is what usually happens. New posts on this blog go into the RSS feed. That feed gets polled periodically by Twitterfeed, which takes the title of the post and the URL (compressed using bit.ly*), appends “#fb”, and creates a new tweet from our Twitter account. (The 13bankers.com feed gets treated the exact same way.) Then the Selective Tweets application for Facebook monitors our Twitter feed; whenever it sees a tweet that ends with “#fb”, it posts it to the Baseline Scenario fan page in Facebook.**

The fact that the links to 13bankers.com continued to work seems to absolve Twitterfeed, bit.ly, and Selective Tweets. However, I have enough software experience to know that things are not necessarily that simple.

So the possibilities seem to be:

1. Facebook doesn’t like bit.ly — doubtful.
2. Facebook doesn’t like anything being promoted by Selective Tweets, as suggested by one commenter — quite possible. This could be a flaky problem, meaning it comes and goes.  (It does seem like the problem appeared briefly on April 23 as well.)
3. Facebook has some kind of algorithm that says, “if the same site gets posted too many times using something that looks like an automatic process, it’s probably spam.” But this seems doubtful, since we are far from the biggest blog that auto-posts to Facebook.
4. A bunch of pro-Wall Street activists (are there such people? aren’t they called “lobbyists”?) figured out how to report to Facebook that baselinescenario.com is really a religious cult indoctrination site, and therefore someone at Facebook (or some program) shut off access to the site.

If anyone knows, or has better theories, please comment. If it happens again, someone please email us at baselinescenario at gmail dot com.

(Incidentally, ours is not the first blog this has happened to. This happened to Cake Wrecks, a blog that highlights really, really bad cakes.)

* Actually, I told Twitterfeed to use Snip instead of bit.ly, but for some reason it’s using bit.ly. But it’s been using bit.ly since long before this problem started.

** I don’t use the main Twitter app for Facebook because, at the time I was setting this up, it didn’t allow you to post your tweets onto a fan page, only onto your personal Facebook page.

So apparently a JPMorgan Chase analyst thinks that senators showed “an unnerving ignorance of fundamental principles of market economics.” Senator Charles Grassley went one better and showed an unnerving ignorance of how the government’s own budget works.

In a hearing on the administration’s proposal to recover the net costs of TARP through a tax on large banks, Grassley said,

“If a TARP tax is imposed and the money is simply spent, that doesn’t repay taxpayers one cent for TARP losses. It’s just more tax-and-spend big government, while taxpayers foot the bill for Washington’s out-of-control spending.”

Grassley apparently thinks that when the government “spends” money, it doesn’t benefit taxpayers. What does he think the government does? Burn it? Give it to Martians?

Apparently according to Grassley, if the government uses the bank tax to cut other taxes or to pay down the national debt, that would “repay taxpayers.” But if the government does any of the following, that is just taxpayers footing the bill for “out-of-control spending”:

1. Pay for Medicare benefits.
2. Pay for extended unemployment benefits.
3. Subsidize student loans.
4. Pay for veterans’ health care.
5. Pay for soldiers fighting in Iraq and Afghanistan.
6. Pay for Head Start teachers.

In 1, 2, 3, and 4, taxpayers get very concrete benefits by virtue of being old, unemployed, students, or veterans. In 5, the benefits are hard to quantify, but few people would say we should spend nothing on national security. I threw in 6 to be “balanced” — it’s something that most Republicans think the government should not be doing.

It is perfectly fine to have debates about the relative value of different forms of government spending. Some government spending counts as productive investments with a positive net present value (think of the interstate highway system, for example), some is pure transfer payments, and some is no doubt wasteful. But saying that when the government collects taxes and then spends tax revenues the people who paid those taxes get nothing in return is pure nonsense.

On the more important issue, I’m glad the administration is pressing for a large bank tax to recover the costs of TARP, because this will have the small effect of creating a disincentive to be large. But politically, it points out the problem with post-funding a bailout, which the administration favors. (The administration was against the Dodd plan to pre-fund future resolutions of large financial institutions.) The banks and their supporters are arguing that now is the wrong time to raise money from large banks, because that would crimp the economic recovery. This is precisely the reason why the funds should be raised before the crisis, during the boom.

After months of denial, the European policy elite finally begins to understand that something is seriously wrong in the eurozone.

But the prevailing definition of the problem is still too narrow – the consensus in France and, even more, in Germany is that “this is a Greek problem”.  Even the most negative still think that Portugal and Spain can easily escape serious damage.

This is a major misconception, as we pointed out last week – and as we have been emphasizing, to anyone who would listen, for more than a year.

If you want to call for a “rescheduling” of Greece’s debts – a position that is becoming increasingly popular among leading north European intellectuals – that is fine.  But you also need to recognize that the policy elite (central banks and ministries of finance) are completely unprepared to handle the consequences, which would be immediate and devastating for other weaker eurozone countries.

You simply cannot do a low-cost or small unilateral restructuring of government debt in this kind of situation; the market will at once take that as a signal that Portugal, Spain, Italy and perhaps even Ireland will face difficulties (in fact, this is exactly what spreads in the 2-year European government bond market are saying today).  The French may smile upon such outcomes with a feeling of superiority, but they might also consider not throwing bricks in glass houses.

It is fine – even appropriate – to emphasize that big European banks have aided and abetted the irresponsible behavior of eurozone authorities.  The profound stupidity of these banks-as-organizations is beyond belief, and it is deeply puzzling quite why leading figures in the US Senate would see them as a model for anything other than what we need to euthanize as soon as possible in the global financial system.

But do not fall into the trap of thinking just because “megabanks are bad” (undoubtedly true) that you can whack them with losses and not face the consequences – these people are powerful for a reason; they hold a knife to our throats.   For all his hubris, missteps, and over-reliance on Goldman group think, Hank Paulson had a point in September 2008: If the choice is chaotic global collapse or unsavory financial rescue, which are you going to choose?

The Europeans will do nothing this week or for the foreseeable future.  They have not planned for these events, they never gamed this scenario, and their decision-making structures are incapable of updating quickly enough.  The incompetence at the level of top European institutions is profound and complete; do not let anyone fool you otherwise.

What we need is a new approach, at the G20 level; this can definitely include debt restructuring, but it has to be done in a systematic fashion (and even then there will be a considerable degree of total mess).  Such a change in framework for dealing with these issues will not get broad support until after further chaos in Europe, but it now needs to be put into place. 

The Europeans will not lift a constructive finger.  The leading emerging markets are too busy battening down the hatches (and accumulating ever more massive chests of reserves).  And the White House still seems determined to sleep through this crisis.  Expect nothing.

The news these days is largely about the financial reform bill on the floor of the Senate. I think you know my opinion about that: many good things, not enough to solve the root problems, but still better than nothing.

Here’s a simplified way of thinking about things. There are two general problems with the financial sector today, which were the subject of two consecutive columns by Paul Krugman. The first problem, according to Krugman: “Much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors.” This is what we see in the SEC-Goldman suit, the Magnetar trade, and so on. The financial reform bill is largely (but not exclusively) aimed at this problem; that’s why there are a consumer protection agency, new trading and clearing requirements for derivatives, etc. These reforms, I think, have a reasonable chance of doing good.

The second problem, again in Krugman’s words:

“The reforms currently on the table . . . only deal with part of the problem: they would make finance safer, but they might not make it smaller. . . .

“We’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy.”

This is the long-term challenge (see my charts here). Finance is an intermediate input. At the margin, every little innovation that makes markets more liquid does provide a small benefit to the economy in the form of better capital allocation; but in many cases those benefits are not enough to justify their transaction costs, let alone the negative systemic externalities we saw recently. The flowering of finance in the past three decades gave us the illusion of growing real GDP — especially in the past decade, when GDP growth was dominated by finance and real estate. Now we need to rebalance the economy toward productive activities.

The bad news is that the administration and Democrats in Congress will face a strong temptation to pass the reform bill and declare victory. The conventional wisdom is that you don’t get re-elected by saying, “We passed a bill that is pretty good, but doesn’t solve the root problems, so we need to do more in the future.” It’s better politically to say you fixed the problem once and for all, then cross your fingers and hope for the best.

The good news is that there seems to be a growing number of voices saying that we need structural change in the financial sector. Besides Krugman and Arianna Huffington, Martin Wolf has chimed in as well, arguing that making the current system safer, though necessary, is insufficient:

“The financial system would remain a doomsday machine. There are three difficulties. First, there is no sound basis for deciding how much capital is enough. Second, . . . it is profitable to take risks whose upside accrues to oneself and whose downside accrues to others. So the safer regulators try to make the system, the more risk it can take on. Finally, it is easy to create the desired risk via regulatory arbitrage.”

Serious academic economics is also questioning the value of a large financial system. A paper by Nicola Gennaioli, Andrei Shleifer, and Robert Vishny (cited by Krugman here) shows how excessive production of securities (the phenomenon of the past decade) can be caused by mistakes in risk perception, making the financial system more fragile as a result. (As a another result, the social benefits of innovation can be outweighed by the social costs.)

So in the long term, I agree with Krugman: “These [current] reforms should be only the first step. We also need to cut finance down to size.” Given that whatever comes out of Congress will be imperfect in anyone’s eyes, whether the Obama administration agrees will be of crucial importance.

The Greek “rescue” package announced last weekend is dramatic, unprecedented, and far from enough to stabilize the eurozone. 

The Greek government and the European Union (EU) leadership, prodded by the International Monetary Fund (IMF), are finally becoming realistic about the dire economic situation in Greece.  They have abandoned previous rounds of optimistic forecasts and have now admitted to a profoundly worse situation.  This new program calls for a total of 11% of GDP in terms of “fiscal adjustments” (i.e., reduction in the budget deficit; now meaning government spending cuts mostly) in 2010, 4.3% in 2011, and 2% in 2012 and 2013.  The total debt to GDP ratio peaks at 149% in 2012-13 before starting a gentle glide path back down to sanity.

This new program is honest enough to show why it is unlikely to succeed.  Daniel Gros, an eminent economist on euro zone issues based in Brussels, has argued that for each 1% of GDP decline in Greek government spending, total demand in the country falls by 2.5% of GDP.  If the government reduces spending by 15% of GDP – the initial shock to demand could be well over 30% of GDP.  Obviously this simple rule does not work with such large numbers, but it illustrates that Greece is likely to experience a very sharp recession – and there is substantial uncertainty around how bad the economy will get.  The program announced last weekend assumes Greek GDP falls by 4% this year, then by another 2.6% in 2011, before recovering to positive growth in 2012 and beyond. 

Such figures seem extremely optimistic, particularly in face of the civil unrest now sweeping Greece and the deep hostility expressed towards Greece in some north European policy circles. 

The pattern of growth is critical because, under this program, Greece needs to soon grow out of its debt problem.  Greece’s debt/GDP ratio will be a debilitating 145% of GDP at end 2011.  If we put more realistic growth figures into the IMF forecast for Greece’s economy, e.g., with GDP declining 12% to end 2011, then the debt/GDP ratio may reach 155%.   At these levels, with a 5% real interest rate and no growth, the country needs a primary surplus at 8% of GDP to keep the debt/GDP ratio stable.  They will be nowhere near that level.  The IMF program has Greece running a primary budget deficit of around 1% of GDP in that year, and that assumes a path for Greek growth that can only be regarded as an “upside scenario”. 

The politics of these implied budget surpluses remain brutal.  Since most Greek debt is held abroad, roughly 80% of the budget savings the Greek government makes go straight to Germans, French and other foreign debt holders (mostly banks).  If growth turns out poorly, will the Greeks be prepared for ever tougher austerity to pay the Germans?  Even if everything goes well, Greek citizens seem unlikely to welcome this version of their “new normal”.

Last week the European leadership panicked – very late in the day – when they realized that the euro zone itself was at risk of a meltdown.  If the euro zone proves unwilling to protect a member like Greece from default, then bond investors will run from Portugal and Spain also – if you doubt this, study carefully the interlocking debt picture published recently in the New York Times.  Higher yields on government debt would have caused concerns about potential bank runs in these nations, and then spread to more nations in Europe. 

When there is such a “run” it is not clear where it stops.  In the hazy distance, Belgium, France, Austria and many others were potentially at risk.  Even the Germans cannot afford to bail out those nations.

Slapped in the face by this ugly scenario, the Europeans decided to throw everything they and the IMF had at bailing out Greece.   The program as announced has only a small chance of preventing eventual Greek bankruptcy, but it may still slow or avert a dangerous spiral downward – and enormous collateral damage – in the rest of Europe. 

The IMF floated in some fashion an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities.  This is not a surprise – leading European policymakers are completely unprepared for broader problems that would follow a Greek “restructuring”, because markets would immediately mark down the debt (i.e., increase the yields) for Portugal, Spain, Ireland, and even Italy.  The fear and panic in the face of this would be unparalleled in modern times: When the Greeks pay only 50% on the face value of their debt, what should expect from the Portuguese and Spanish?  It all becomes arbitrary, including which countries are dragged down.  Someone has to decide who should be defended and at what cost, and the European structures are completely unsuited to this kind of tough decision-making under pressure. 

In the extreme downside scenario, Germany is the only obvious safe haven within the eurozone, so its government bond yields would collapse while other governments face sharply rising yields.  The eurozone would likely not hold together.

There is still a narrow escape path, without immediate debt default and the chaos that would produce:

1.  Talk down the euro – moving towards parity with the US dollar would help lift growth across the eurozone.

2.  As the euro falls, bond yields will rise on the eurozone periphery.  This will create episodes of panic.  Enough short-term financing must be in place to support the rollover of government debt.

3.  Once the euro has fallen a great deal, announce the ECB will support the euro at those levels (i.e., prevent appreciation, with G20 tacit agreement), and also support the peripheral eurozone nations viewed as solvent by buying their bonds whenever markets are chaotic. 

4. At that stage, but not before, the eurozone leadership needs to push weaker governments to restructure – that will include Greece and perhaps also Portugal?  Hopefully, in this scenario Spain can muddle through.

5. European banks should be recapitalized as necessary and have most of their management replaced.  This is a massive failure of euro groupthink – including most notably at the political level – but there is no question that bank executives have not behaved responsibly in a long while and should be replaced en masse. 

To the extent possible, some of the ensuing losses should be shared with bank creditors.  But be careful what you wish for – the bankers are powerful for a reason; they have built vital yet fragile structures at the heart of our economies.  Dismantle with care.

An edited version of this post appears this morning on the NYT’s Economix and is used here with permission.  If you wish to republish the entire article, please contact the New York Times.

When you strip away the disinformation, false promises, and wishful thinking, this is where we are on really reigning in the power of the country’s largest – and most dangerous – banks.

Senators Sherrod Brown and Ted Kaufman have proposed the SAFE Banking Act, which is an entirely reasonable and responsible way of limiting the size of our largest banks.  It should be adopted as an amendment to the main financial reform bill now before the Senate.

As the New York Times points out today, there is growing support for this approach.  But note that this article – while entirely accurate – was relegated to page B3; Sewell Chan’s original piece on this topic was a front page story on April 20. 

The opposition to Brown-Kaufman at the highest levels of government (legislature and executive branches) is so strong that it is increasingly unlikely the amendment will even get an up-or-down vote on the Senate floor.

The NYT’s editorial page has endorsed Brown-Kaufman, as have a growing number of organizations that want to see some meaningful financial reform. 

But opposition to Brown-Kaufman (and actually any real reform) is deeply entrenched among prominent senators and even the White House.  They fall back on increasingly specious arguments, completely unencumbered by the evidence or any real head-to-head debate. 

These people may well be soon forgotten – or even as widely disparaged in a few years as the once-ascendant Robert Rubin and Alan Greenspan are today.  But for the moment their power on Capitol Hill is almost unbreakable.

This is not about ideology any more – it is hard to find anyone who will argue in public that finance is always good, unfettered finance is better, and largely unregulated big banks are the best.  This is a major and encouraging break from the history of the past 30 years – as told, for example, in 13 Bankers.

The revolving door between Washington and Wall Street is also playing less of a role than in the past (again, we review the recent decades of evidence in 13 Bankers).  To be sure, there are still plenty of lobbyists with Capitol Hill experience, but it is no longer fashionable for a top senator or treasury official to go easy on big banks and then slip into a comfortable boardroom for well-remunerated slumber (talk to Robert Rubin or Phil Gramm).  We may see some of this, of course, but any such individuals will be pilloried indefinitely and without mercy; their names will live in serious infamy.

The lack of debate over Brown-Kaufman – and its likely demise – is all about money.  There is a tsunami of contributions from the financial sector washing over Congress right now.  When the dust settles, the pattern will be clear: Wall Street (legally) bought off key senators.

There will be a reckoning, to be sure, at the polls.  The supporters of big banks will go down hard in November and in 2012; there are no secrets over this kind of time frame.  But by then it will be too late for this cycle of financial reform – and there is on guarantee that the backlash will bring stronger reformers to power (in fact, the White House and the biggest banks would be quite happy to see non-reformers prevail.)

Call your senator, by all means, and urge support for Brown-Kaufman – or at least press them to allow a Senate floor vote on the issue.

Recognizing the paramount importance of money at this moment, you might also offer to send a $2 bill to every senator who votes for Brown-Kaufman. 

If you haven’t seen the $2 in a while, stop by the bank and get one.  Even if there is never anyone to whom it is worth sending, you can always pin it up in your kitchen as a reminder of what went wrong.  It will be up to you which side to look at more often: Thomas Jefferson, who argued so powerfully against the dangers of a financial aristocracy (see chapter 1 of 13 Bankers); or the signing of the Declaration of Independence.

Update: Tiffiniy Cheng has a “whip count” and suggestions regarding how to sharpen everyone’s focus on key senators

Bernie Sanders’s “audit the Fed” amendment, which expands the ability of the Government Accountability Office to review Federal Reserve operations, seems to be gaining some momentum. Opponents, including the Obama administration and Fed chair Ben Bernanke, are mounting a defensive effort. There are two main arguments that I have heard.

The first is that publicizing which banks take advantage of Fed lending facilities will stigmatize those banks and could increase panic in the midst of a financial crisis. I’m not particularly convinced by this argument, since most supporters of the amendment are fine with releasing such information with a delay. Section 1152(a)(2) of the amendment eliminates the provision in 31 U.S.C. 714(b) that shields from audit monetary policy decision-making and financial transactions by Federal Reserve banks, but replaces it with this:

“Audits of the Federal Reserve Board and Federal reserve banks shall not include unreleased transcripts or minutes of meetings of the Board of Governors or of the Federal Open Market Committee. To the extent that an audit deals with individual market actions, records related to such actions shall only be released by the Comptroller General after 180 days have elapsed following the effective date of such actions.”

Transparency is supposed to be good for markets, because it gives parties in the market the information they need in order to make rational decisions. I understand the concern that immediate disclosure could make banks avoid using Fed lending facilities in a crisis, which could be bad. But I don’t see why the 180-day delay doesn’t solve this problem. Let’s say (for argument’s sake) that Goldman Sachs borrowed money from a Fed liquidity program in May 2008. If they can’t bear the market receiving this news in November 2008, doesn’t that imply that they really are in big trouble, and the market should know about it? In other words, Goldman and the Fed have six months to solve whatever problem Goldman had. If they can’t solve it by then, then Goldman is no longer worth protecting.

The second argument is that increased GAO oversight will unduly “politicize” or “interfere with” monetary policy. On its face, this objection doesn’t seem to apply, since the amendment would explicitly not bring to light transcripts or minutes of meetings that the Fed had not itself already released.

More fundamentally, though, this objection rests on a disturbing view of how government should operate. Equating information with politicization or interference is a misleading way to justify undemocratic processes. In general, government agencies are supposed to be overseen by Congress (of which the GAO is an arm). As a basic principle, it’s good that the people’s elected representatives have visibility into what the other arms of the government are doing, so that they can make better decisions about, for example, whether heads of regulatory agencies should be reconfirmed, or whether the statutes governing those agencies should be modified. We even have Congressional oversight over deeply secretive operations, such as our intelligence operations. If “politics” means accountability to officials who are actually accountable to the people, then that’s a good thing.

There is a lot of skepticism about Congress these days, and that skepticism is justified. But the alternative — allowing government agencies to operate in secret because we think our Congressional representatives are bozos — is worse.

But the Fed is different, people say. Monetary policy is so technical, and so hard to explain to the public, and so dependent on the credibility of the central bank, that any exposure to politics would be dangerous.

The idea that monetary policy is too technical for Congress to understand, and therefore should be done in secret, I don’t buy. So is, say, climate policy. That’s a complex scientific topic, of crucial importance to the future of our nation (and the human race), that is clearly beyond the ability of Congress to understand and discuss responsibly. But we don’t exempt the EPA from Congressional oversight.

The idea that monetary policy, to work at all, must be sealed off from political interference has a little more merit to it. The idea (to simplify) is that elected politicians always want to lower interest rates in order to boost growth and jobs; in order to maintain inflation-fighting credibility, central banks have to be completely apolitical, and the markets have to believe that they are apolitical. But from there to the idea that there must be a blanket of secrecy over all decision-making is much too large a leap.

Ryan Grim’s article discussing Federal Reserve transcripts from 2004 is especially instructive in this context. The article focuses on a meeting of the Open Market Committee at which there was debate about whether there was an unsustainable housing bubble. The minutes of that meeting, released the same year, whitewashed the debate. More revealingly, the recently-released transcript includes this gem from Alan Greenspan:

“We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.”

That is the money quote of this whole debate about the Fed, and I’m sorry I buried it 750 words into this post. (I’m not a news reporter, as you no doubt know.) The Fed and its defenders think that monetary policy should be entirely up to them — which it is — and that no one else should even participate in the debate. They are so concerned about this prerogative that they react violently even to suggestions that Fed policy-making should be reviewed after the fact.

This goes hand-in-hand with the idea that the Fed chair is a de facto dictator and that even questioning him is economic treason. We saw this during the Bernanke reconfirmation debate, when supposed experts and Wall Street insiders claimed that, were Bernanke to be voted down, the markets would collapse. I think this claim is almost certainly false, but if it were true that would be even worse: how can it be a good thing that our economy is held hostage to the health of a fifty-six-year-old man? (And Greenspan was seventy-nine when he stepped down.)

Look, we all know there are debates about monetary policy. Intelligent economists have them all the time in public, and Federal Reserve bank presidents have them as well through their public appearances (though in somewhat measured tones). We all know what the arguments on the various sides of those debates are. What we gain by trying to hide them and pretending they don’t exist — except for increasing the dangerous mythology of the omniscient Fed chair — is beyond me.

Monetary policy is important. It is also somewhat technical. It should not be decided by vote of Congress every six weeks. That’s why we entrust it to a committee of twelve people, seven of whom are presidential appointees confirmed by the Senate and five of whom are bank presidents chosen by boards of directors themselves chosen (in a majority) by private banks. Their actions (raising or lowering key rates) are announced the same day that they meet, and commentators jump all over them immediately. The idea that Ben Bernanke would do something he thought was bad for the economy because he was afraid of what a GAO report might say about his decision-making process (remember, the decision is public immediately) is both preposterous and, frankly, insulting to Ben Bernanke.

I don’t actually think auditing the Fed is the most important step we need to take to fix our financial system. And I am open to considering alternatives to the Sanders amendment, if any serious ones were to be put forward. But hiding behind the idea that the Fed is so magical that it has to be hidden from the people it serves is about as undemocratic as it gets.

PS: In Chapter 6 of their forthcoming Crisis Economics (I got a free advance copy from Roubini Global Economics), Nouriel Roubini and Stephen Mihm dicsuss how the Fed’s role changed during the recent crisis — from a traditional “lender of last resort” model to an “investor of last resort” model in which the Fed bought up all kinds of non-traditional assets (e.g., long-term Treasuries, agency bonds) in an attempt to stop the economic downturn. Roubini and Mihm are generally positive about the short-term impact of these policies. But, they argue, by taking the Fed far afield from its traditional scope of action, they raise the issue of democratic accountability:

“The Fed has instead stepped into the financial system and effective subsidized its operations, potentially incurring losses that could ultimately fall on the shoulders of taxpayers. Put differently, it’s engaging in monetary policies that bleed imperceptibly into the traditional domain of fiscal policy — namely, government’s power to tax and spend. Those are prerogatives of the legislative branch, but in this crisis Bernanke’s policies have blurred that line.”

In another passage, they refer to this as “an end run around the legislative process.” This, it seems to me, strengthens the argument that increased oversight of the Fed is warranted.

PPS: Brad DeLong has an argument against the Sanders amendment. But his argument seems to be that the Sanders amendment does not solve the real problems with the Fed:

“I do not think that the Federal Reserve is working reasonably well. I do not think that the dominant views of monetary policy in the FOMC right now are informed by American values and a reality-based assessment of the state of the economy. That a good many of the people speaking and voting in the FOMC are the wrong people to do so did not matter (much) when the Federal Reserve was dominated by the incredibly charismatic (yes, I mean that) philosopher-central banker-princes of William McChesney Martin, Arthur Burns, Paul Volcker, and Alan Greenspan, but it matters now.”

I’m not sure DeLong makes a strong case in his post that the Sanders amendment is actually bad — just that the Fed’s problems go deeper than those that will be solved by greater oversight.

Europe needs a new recovery plan, bigger and broader than anything put together so far.  This weekend is the perfect time to put such a plan together.  But be wary of committing official resources too early in this market downdraft – smart policymakers will calmly let the markets fall further, in order to benefit from the rebound potential.

In the last few days, bond markets have decided that the deflationary adjustments – cutting wages and prices — needed in large parts of the eurozone are not politically feasible.  The deflationary spiral that will come with fiscal cuts causes political turmoil and reduces revenues – that in turn makes it ever harder to service debt; see Greece this week.  Eurozone countries running large budget deficits with substantial outstanding public debt are finding they are cut off from credit markets as a result.  This is a solvency issue, not a liquidity issue.

But do not rush into this gap.  If the European Central Bank (ECB) were to start buying Spanish debt today, for example, they would find an abundance of sellers because the bonds are fundamentally overvalued. 

There is a good rule for foreign exchange intervention:  you intervene to buy a currency at a time when you think you can really shift events – i.e., when the exchange rate has fallen more than really makes sense and shorting the currency has become overly fashionable.  In that way you cause traders with short positions to lose a considerable amount of money, and you draw in real buyers who want to own the assets because they are inexpensive and can now see an end to the declines.

We are not yet at that point in the bond markets for weaker eurozone countries or in the foreign exchange market for euro. 

Start with bonds:  Greece clearly must end up restructuring its debt.  The IMF program makes that obvious – how can Greece make a total of 19% of GDP in cuts, only to end with 149% of GDP in debt, and a perpetual bill to pay German, French, and other foreign holders roughly 10% of income each year just to cover interest? 

This is a political disaster for all concerned and should be cleaned up now rather than left to ferment. The markets, with their high interest rates on Greek debt, show they believe this is the outcome.   The market prices in about a 29% chance that Greece’s default within one year, and 35% over two years (assuming a 40% recovery rate on Greek bonds after default and restructuring). 

Portugal should restructure preemptively – they have a large budget deficit and current account deficit, and will have similar problems cutting the budget deficit.  When the government takes fiscal austerity measures, unemployment will rise further, the economy will slow, so revenues will fall, and that will mean they make too little progress bringing in their deficit. 

Spain is in a very difficult position.  It is unlikely they can avoid restructuring for the same reasons as Portugal and Greece, but they are starting from a position with less public debt outstanding (if the numbers are correct).  However, Spanish banks own a great deal of Portuguese debt, so if Portugal restructures it poses a major additional burden on Spain. 

Italy and Ireland are clearly in trouble also, depending on exactly how expectations for eurozone growth are revised downwards.  Given all these nations probably need to restructure their debt, or have large bailout packages that may not succeed in any case, we cannot expect bond markets to rally at this time.  “Investment grade” investors, finally waking to the problems in the market, now fear holding these bonds. 

The traditional holders of these bonds, such as AXA the French insurance group, or German Commerzbank, are telling investors exactly how much risk they have in Portgual-Ireland-Italy-Greece-and-Spain.  The true message is:  “We promise we will not buy more of the these countries’ debt”.  Without the traditional investors available, who is going to finance Spain, Ireland, Italy, and Portugal’s ongoing large budget deficits?

And this is the next problem.  This week the EU commission released its forecasts for budget deficits in 2010 and 2011.  Those were a depressing set of numbers.  They expect Europe will grow by less than 1% this year and only 1.5% in 2011.  Meanwhile, budget deficits would hardly change.  Ireland leads the pack (in a bad sense) with a 11.7% of GDP budget deficit in 2010 and 12.1% in 2011.  Greece, Portugal, Spain are all in the same range – large budget deficits and little improvement on the horizon.  These are unrealistic plans given the lack of buyers for their bonds.  Careful study of the details will only exacerbate concerns about fiscal solvency.

What should economic policymakers – in Europe, the US, and elsewhere – do about all this, for example as they convene in emergency meetings this weekend? 

First, the core problem is that the euro zone as currently designed is a failure.  It has proven wrong to blend so many disparate nations into one currency, and then manage the currency according to relatively hawkish German preferences. 

This is an unfortunate loss of face for the eurozone policy elite, but they need to get over this and move on.

The euro zone in its current form needs to be wound down, most likely being reduced to a core of countries that are sufficiently similar – and without the presumption that others will soon be admitted.  The weaker countries badly need currencies reflect their national fundamentals. Germany does not need a weak currency, but Greece, Portugal, Ireland and Spain today do. 

A depreciation of the euro against the dollar and other major currencies would help.  But these nations trade more with each other more than with non-euro countries, so they need to change competitiveness relative to each other.

Even if by a miracle the worst outcomes are now averted, what will prevent problems like this from happening again if the euro zone stays in place?  The euro authorities have demonstrated repeatedly they are incapable of regulating banks well at the eurozone or EU level – it is unimaginable that the 16 eurozone countries could get together around a table and declare that any one regulator has been seriously derelict.

The planned budget reforms at the EU level will push towards more discipline, but you need an incentive structure to get that and the consensus-based decision-making does not work for that.  If this weekend only produces a reaffirmation of platitudes in this regard, next week will be very bad.  This is fiddling while cities burn.

On top of all this, shocks to economic performance that are different across nations will persist.  Sharing one currency across these very different and insufficiently convergent countries simply does not make sense.

Second, there needs to be an orderly plan for debt restructuring across the euro zone.  This needs to be done quickly (this weekend works, but realistically it will take several weeks), while the exit to a new currency could take longer.  Since most euro zone nations bonds are issued under domestic law, such restructurings should be able to proceed quickly (in emerging markets, most of the bonds are often under US or UK law, which generally makes restructuring much harder).

But do not think that Greece can restructure its debts without having broader repercussions.  All the weaker eurozone countries must proceed together on this front or there will be chaos.

Third, the G20 needs to assist in the euro restructuring project.  This body can authorize the International Monetary Fund to help each affected nation declare a standstill on debt, and then draw up a plan to restructure debt.  The IMF should play a key implementation role in helping to decide which nations should restructure their debts and then support this process – not because it is particularly good or suited to this task, but simply because no one else is available. 

During the next few years each troubled euro nation will need liquidity support from the ECB, and they will need fiscal financing from the IMF and core nations in the EU.  Probably the G20 should commit more resources, at least as a back stop.  These programs can be drawn up quickly, and, they should include a transition to a new currency where appropriate. 

There is no real leadership in the EU, combined with complete unwillingness to admit the fundamental error of the euro zone itself.  The Germans are happy to let other nations suffer for their past mistakes, so they will do nothing until there is a more complete crisis. 

The ECB, as witnessed by Mr. Trichet’s news conference on Thursday, has decided that they will play the hawk, and so offer nothing of support to the nations in the periphery.  Meanwhile, bond markets have closed for the periphery.  This can only mean bond yields keep rising, there are runs on the banks in many nations, and then eventual economic collapse.  This, unfortunately, is the path of least resistance for all parties. 

So, someone needs to take leadership. Who can do this?  Not the IMF by itself – it is too weak and conflicted with Dominique Strauss-Kahn clinging to his position as managing director (against increasing pressure from the United States).  Indeed, Strauss-Kahn should leave the IMF so he can launch his run for the French presidency – it would be appropriately ironic if he were to win; as an architect of the eurozone, he is the perfect person to dismantle it.  A much more independent person with international stature should replace him.

President Obama needs to step in personally to help this process work smoothly.  The president can rightly claim that this is an international issue, not just a euro zone issue, since it impacts global trade and financial stability. All the world’s large banks are closely linked through debt, derivatives contracts, and other finance. 

It would be irresponsible to presume that American banks will smoothly sail through the impending financial collapse in the euro zone.  If this is left to the Europeans, as we learned this week in markets, there is a clear danger that Europe’s problems will topple the world into a new recession and a serious round of financial instability this year. 

Someone needs soon to bring clarity and restore confidence.  If not President Obama, who?

The bank lobbyists have the champagne out – the Brown-Kaufman amendment, which would have capped the size and leverage of our largest banks – was defeated in the Senate last night, 33-61.  Feeling ascendant, the big banks swarm forward to take on their next foe – the Kanjorski amendment (that would greatly strengthen the power of regulators to break up megabanks), which they plan to gut in the backrooms.

This is overconfidence – because the consensus against them is beginning to shift significantly.  Partly this is the result of great efforts by Senator Ted Kaufman, Senator Sherrod Brown, and their colleagues over recent months and weeks.  Partly this is due to all the people who came on board and pushed hard.

But, as in many such cases, it is also a question of luck – and timing.

The European sovereign debt crisis is deepening.  And the picture that is worth many thousands of words is the NYT’s graph of interlocking debt within the eurozone.

As far as anyone can ascertain, this is almost all debt held by banks (often then “repo-ing”, or borrowing against it as collateral, at the European Central Bank.)

In other words, the European megabanks – lauded by Senators Dodd, Corker, Warner and others as a model for us to follow – are up to the eyeballs in bad debt.  Their governance has completely failed.  Their regulatory systems have been gutted – on their way to being turned into ash.

None of this would matter, of course, if the eurozone policy elite had its act together and could terminate its current position with minimal losses.  But it cannot – the deer are in the headlights.

Ask everyone this question:  Which are the huge global banks that Senator Dodd, Jamie Dimon, and Larry Summers think we should be emulating?  Surely not the Chinese – their governance failures are profound and complete; this is state banking run amok.  Surely not the British – after all Mervyn King and Adair Turner, the top authorities on those banks, are globally the most articulate officials on how good finance has gone so deeply wrong.  Surely not the Canadians – those myths have been long exploded (and without dissent, in our conversations with the Bank of Canada).

And surely you are not proposing that the continental European banks are a model of anything other than ineptness, blind herding, and the transition from being “too big to fail” to “so big that even when you save them, you get an economic catastrophe”?

To the victors last night in the Senate: congratulations – your opponents have fallen back.  Your generals are known to be invincible, your forces are the best, and your resources are without limit.

And so we wait for you again, on a gentle slope and behind a ridge – appropriately enough with our backs to Brussels.  Welcome to Waterloo.