Via Yves Smith, John Hempton analyzes the quarterly results of Bank of America (so-so) and Fannie Mae (terrible). The underlying issue is that bank quarter-to-quarter results are largely driven by the amount of provisions they take against future loan losses. You can think of this as a very rough approximation to marking-to-market — instead of waiting for the loans to default, you estimate how many loans will default in the future (that estimate should change as the economic situation changes) and put that amount of money into reserves. Then when the defaults actually happen, you take the money out of reserves.

Hempton argues that Bank of America and Fannie Mae are estimating extremely different future loan losses, and those differences cannot be attributed to differences in their current performance (the rate at which loans are defaulting now). If I wanted to be provocative I would only show you this quote:

“If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.” [emphasis in original]

(“Totally cactus” — I like that.)

But to be fair, Hempton actually thinks that Bank of America is being only slightly optimistic and Fannie is being extremely pessimistic. Here’s his interpretation:

“[R]egulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

“It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. [Hempton is saying that if they took any more provisions they would be unprofitable.] Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible. …

“[A]lmost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

“Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.”

By James Kwak

On Monday the Treasury Department (various officials, including Geithner, in shifts) had an informal meeting with eight prominent finance or economics bloggers. I’ve only read the accounts by Tyler Cowen, Steve Waldman, and Yves Smith; Waldman names all of them and links to other accounts. This is Smith’s sum-up:

“[T]hese guys are very smooth, very smart, and seemed quite sincere, which made it difficult to discern how much they really did believe and how much of what they said they had to say because they need to defend official policy and maintain confidence. Let’s face it, they get prodded and roughed up by big dogs with some frequency. There was nothing we asked that would be new. They’ve covered this ground with other people of more consequence and therefore have answers ready. We are a pretty unimportant audience (yes, they did bother making time for us, but let us not kid ourselves on how far down the food chain bloggers are) and we cannot argue from a position of advantaged information, so it was inevitable that we would not get beyond standard responses.”

I give Treasury big points for acknowledging us bloggers and inviting some pretty severe critics, such as Smith. I separately give them points for being good at their jobs. They understand that public opinion matters; they understand that bloggers have some influence on public opinion, if not that much; they understand that it’s a little harder to criticize someone after you’ve met him and he’s given you free cookies (“The free cookies were good and fresh, with a warm, fluid chocolate interior.” – Cowen; note also that when the bank CEOs went to Washington in March all they got was water, no cookies.); and even if they couldn’t possibly have expected to change anybody’s mind, they understand that it’s better to talk to your critics than to avoid them. Waldman talks about some of the techniques used to make the attendees feel like they were being treated as special guests.

On a substantive point, Waldman said this:

“A Treasury official pointed out that eliminating ‘too big to fail’ doesn’t solve the problem, since institutions can be systemically important because of their interconnections and roles along a wide variety of dimensions. I responded that ‘too-big-to-fail is too stupid a criterion,’ but pointed out that it would be possible to progressively tax several of the various markers of criticality so that it becomes uneconomic for an institution to remain indispensable.”

I think this whole “interconnectedness” theme is a clever rhetorical trick — a way of defusing the “too big to fail” argument by making a correct but ultimately minor point. I agree that if you simply cap balance sheet assets, that will not be enough. Technically speaking, a derivatives dealer can have ZERO balance sheet assets yet have an unlimited amount of open derivatives positions. If my memory of When Genius Failed is correct, LTCM just before its collapse had about $130 billion in assets and $1.4 trillion in open derivatives positions (that’s market value, not notional) on top of $4 billion in capital.

But who said that “big” in “too big to fail” had to mean balance sheet assets? When I say “big,” the concept I am referring to is the overall shadow the institution casts over the financial system and the amount of collateral damage it would cause were it to fail. That damage can take various forms: debt that becomes worthless, derivatives positions that can’t be closed, hedge fund collateral that can’t be pulled back, etc. So call it “too interconnected to fail” or “too systemically important to fail” if you want, but you haven’t made the problem go away. The only thing you’ve done is pointed out that it can be tricky to measure overall importance, but none of us ever denied that to begin with.

By James Kwak

President Obama leaves next week for a high profile trip that includes meetings with other “Asia-Pacific” countries (in the APEC forum) and a visit to China.  The President has had considerable diplomatic success on the economic front to date, including at the G20 summit in April and – to a lesser degree – at the follow-up September summit in Pittsburgh.

But the issues facing him now in Asia are particularly difficult, primarily because of China’s exchange rate policy.  China essentially pegs its currency (known as the yuan or renminbi) against the US dollar, which means that it rises and – most recently – falls in tandem with the greenback.

Many countries operate de facto pegs of this nature, but China is problematic for three reasons: it is a large economy (10 percent of world GDP, if we adjust for purchasing power), it runs a big current account surplus (exporting more to the world than it buys from the world, in the range of 6-12 percent of the Chinese economy), and it consistently has a bilateral surplus with the US that is galling to many on both sides of the aisle on Capitol Hill (and their constituents).

The political backlash is not without foundation – jobs have moved and continue to move to China in part because Beijing’s exchange rate policy gives Chinese exporters an unfair trade advantage.  This has long been recognized and China committed as long ago as 2003 to address this issue, but the Bush administration was unable to achieve any lasting success on this front – despite repeated head-to-head talks at the Cabinet Secretary level. 

The Chinese currency remains at least 20 percent undervalued according to the Peterson Institute for International Economics (disclosure: I have a part-time position at the Institute but don’t work on this calculation); quietly, US officials do not disagree with such numbers.  As a result, China continues to accumulate foreign exchange reserves at a dramatic rate – it reached $2 trillion earlier this year and will like have $3 trillion around the middle of 2010 (i.e., equivalent to 20 percent of US GDP; a huge number).

The Bush administration, quite reasonably, tried to give the job of handling China’s exchange rate to the International Monetary Fund – beefing up its long-established mandate in this area.  Unfortunately, the IMF has proved unable to make any significant progress, largely because it lacks the legitimacy necessary to wield any kind of stick on the issue.  The Chinese just continue to say “no”, politely, and the IMF has backed down.   

This is embarrassing for Mr. Obama, particularly as his strategy at the G20 has been to play up the importance of “global imbalances,” which implies that over the next 12 months, the focus will be on reducing both the Chinese current account surplus and the US current account deficit.

What should he say both to China and to its neighbors – who also increasingly find China’s exchange rate policy worrying, particularly as the dollar faces pressure to decline?  Mr. Obama needs to find a carrot and at least the shadow of a stick, but he really does not want to go anywhere near a trade war (remember the tit-for-tat protectionism of the Great Depression).

A compelling argument is actually hiding in plain sight.  As a result of easy monetary policy in the United States, combined with the rapid rebound of the Chinese economy, China now faces record capital inflows.  These inflows are greatly encouraged by the inevitable prospect (in the minds of investors) that the renminbi will rise in value against the dollar within the foreseeable future.  If you have access to cheap financing and implicit US government guarantees, for example as does Goldman Sachs, borrowing in dollars and investing (e.g., through private equity deals) in renminbi looks like a one-way bet.

The longer China resists appreciation and the more it protests that no one should interfere with this aspect of their sovereignty, the more the capital will pour in.  This can have beneficial aspects, in any country that is trying to grow fast, but it can also be profoundly destabilizing – Mr. Obama should talk gently about the experience of Japan in the 1980s, the US this decade, and almost all emerging markets pretty much every decade.

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction.  But the mainstream consensus is starting to shift towards the idea that the World Trade Organization (WTO), not the IMF, should have jurisdiction over exchange rates.  The WTO has much more legitimacy – primarily because smaller and poorer countries can bring and win cases against the US and Western Europe in that forum.  It also has agreed upon and proven tools for dealing with violations of acceptable trade practices – tailored trade sanctions are permitted.

No one wants to take precipitate action in this direction, but extending the WTO’s mandate in the direction of exchange rates would take time – and presumably warrant discussion at the G20 level.  The US has great influence over the G20 agenda and Mr. Obama’s staff should hint, ever so gently, that this is where they see the process going.

By Simon Johnson

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

In a free market, companies should be allowed to decide whether or not to offer paid sick leave to employees. At the margin, employees who value paid sick leave will flow to companies that offer it and employees that don’t won’t; also at the margin, companies that offer paid sick leave will be able to pay their employees a little less in other forms of compensation. Everything works out for the best.

Unfortunately, not offering paid sick leave creates a classic externality: People go to work even when they’re sick, infecting their co-workers (or customers); employers internalize some of that cost (co-workers), but not all of it (co-workers going home and infecting their kids, who then go to school — because their parents can’t stay home to take care of them — and infect their classmates, etc.). I’ve written before that we are far behind the rest of the developed world in requiring paid sick leave.

Now is when it will hurt us. The New York Times has an article today titled “Fears That Lack of Paid Sick Days May Worsen Flu Pandemic.” (Economix has related data on who gets paid sick leave — public sector workers, people at big companies, and the highly-paid.) I’m not sure why they decided to throw in the word “may.” We know that at the margin some people with H1N1 are going to work when they shouldn’t. We know that H1N1 is highly contagious (5.7 million Americans affected so far). We may not know how many more people are getting H1N1 because of our non-policy on paid sick leave, but it can’t be zero.

Of course, you can count on the business lobby to deny that there is a problem:

“‘The vast majority of employers provide paid leave of some sort,’ said Randel K. Johnson, senior vice president for labor at the United States Chamber of Commerce. ‘The problem is not nearly as great as some people say. Lots of employers work these things out on an ad hoc basis with their employees.’

“According to the Bureau of Labor Statistics, 39 percent of private-sector workers do not receive paid sick leave.”

Vast majority?

There’s another dimension to this, too. Economix says this: “In both the private and the public sector, low-wage workers are far less likely to receive paid sick leave than high-income workers, touching off fears that front-line workers at fast-food restaurants or child care centers might be spreading their illnesses.”

That’s an interesting interpretation: the problem is that readers of Economix, who presumably do not work in fast food restaurants or day care centers, might catch H1N1 from a fast-food worker or their child’s day care provider. No, it isn’t. The problem is that our non-policy hurts the poor. Rich people can stay home when they are sick or when their children are sick, which means the rate of transmission in rich communities will be lower. Poor people can’t, so the rate of transmission in poor communities will be higher. This is obviously a simplification; there are poor people with paid sick leave, and rich people without it (many small business owners, for example). There are also communities that include rich and poor people. But in the absence of public policy not only do we have a negative externality, we have one that disproportionately affects the poor.

By James Kwak

Yesterday Maine voted to restrict marriage to opposite-sex couples. It’s a sad day for people who believe that all couples who love each other should be allowed to marry, full stop.

But the chart below may cushion the blow a tiny bit. It’s from a paper by Jeffrey Lax and Justin Phillips, “Gay Rights in the States: Public Opinion and Policy Responsiveness,” recently published in the American Political Science Review (via The Monkey Cage). What you are seeing is support for same-sex marriage in 1994-96, 2003-04, and 2008-09; solid dots indicate that same-sex marriage is equal, hollow dots that it is not.

Similarly, here’s the picture of recent (2008) support for same-sex marriage by age group:

Barring a backlash even bigger than the one we’ve seen over the last ten years (during which support for same-sex marriage increased in every state except Utah), time is on the side of same-sex marriage. That may still be small consolation to elderly couples who have been together for decades.

By James Kwak

On October 24, we published a guest post, “Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors,” by Peter Fox-Penner.  Below is his response to some of your more than 200 comments.

As a stuck-in-the-last-century guy, I’m remiss in not replying to the many comments to my guest post. As an I-O (industrial organization) economist, I learned a lot more than I contributed reading the many colloquies.  Here are just a few general observations stimulated by the discussion:

To start off, there seems to be agreement on the difficulty of measuring risk, either because there is no transparency and/or the instruments are so darn complex.  Incidentally, the best short piece I’ve ever read on the emerging science of systemic risk measurement is Andrew Lo’s Senate testimony; perhaps all of you have other good pieces.  The one thing I learned from Andrew’s piece is that we are a long way from knowing how to do it.

Many folks agreed that if you can’t measure – it you can’t regulate it.  Bond Girl and others worry that regulation will stifle innovation.  In my view, there is no question about it.  There is no free lunch.  Regulation reduces the variance in outcomes in a market – that’s its job.  Innovation increases them and even disrupts the distribution.  When disruptive events have large economic fallout, or violate our norms for justice, the cost of diminishing these risks via regulation outweighs the costs of reduced innovation.  

More practically, however, this is not a question of zero innovation versus zero regulation.  All regulation allows for innovation – it just reduces and controls it.  New drugs are introduced – lots of them.  New electric power pricing approaches are approved.  And thank you, James Kwak, for reminding commenters that I don’t say “ban derivatives”, I say “oversee them properly.”  Furthermore, it is not just the regulated products that evolve – it is also regulatory processes themselves.  There is a steady stream of regulatory decisions that find their way into the courts precisely because the regulator did something different this time around and one party challenges whether this (dare I say it) innovation is consistent with the regulatory agency’s  legal charter.

Every regulator allows innovation – some even encourage it.  But under prudent regulation, you don’t allow a product to be introduced in widespread ways that might undermine the whole goal of your regulatory scheme.  Financial regulators did – though it was partly because their authority was balkanized so that new products had no natural regulator.   In the end, that’s Joskow’s point and mine as well.  Mind the gap, as they say in the London tube.

Redleg asked a simple, fair question: “Doesn’t simplifying the regulatory system simplify how one might compromise it?”  In my own limited experience: “No.”  Simpler systems are harder to compromise because many more people understand them and can therefore police them, formally or informally.  Regulatory agencies don’t need as high a level of skill.  So let’s be clear: regulation should be as complex as is necessary to do a good job, but not more so, and regulators MUST have the resources (educational and otherwise) necessary for their job.   

Regulatory capture is unquestionably a huge and generally not solvable issue.  It is an unavoidable aspect of regulation that civil society must seek to minimize.  There is a century of experience with mechanisms that reduce capture: overlapping terms of regulators, requirements for political balance, revolving door rules, and so on.  This is the hugely important day to day work of regulatory practitioners and legislative overseers.

Finally, Uncle Billy makes a number of points about Commissions, including the Pecora Commission.  In the current ultra-polarized legislative climate, I think these commissions are extremely important and I have high hopes for what I will now call the Angelides Commission. 

As to my background and motivation, my vita is posted on the Brattle website at www.brattle.com and more is at www.smartpowerbook.com.  No Brattle client (or anyone else) knew that I was doing this post, much less reviewed it, much less paid for it.  (However I do genuinely like Rowe and Joskow).  See the disclaimer at the start of the post.  And yes, we are proud to consider Simon a senior advisor to our firm.   I sought out Simon to contribute to the discussion and he consented, not the reverse. 

By Peter Fox-Penner

Peter is a leading expert on regulation at The Brattle Group.  The views expressed here are his alone.

Josef Ackermann, chief executive of Deutsche Bank and chairman of the Institute of International Finance (an influential group, reflecting the interests of global finance in Washington) is opposed to breaking up big banks.  According to the FT, he said,

“The idea that we could run modern, sophisticated, prosperous economies with a population of mid-sized savings banks is totally misguided.”

This is clever rhetoric – aiming to portray proponents of reform as populists with no notion of how a modern economy operates.  But the problem is that some leading voices for breaking up banks come from people who are far from being populists, such as the UK authorities (in the news today) and the US’s Thomas Hoenig.

Hoenig is an experienced regulator, who has dealt with many bank failures.  He is also currently President of the Kansas City Fed and an articulate voice regarding how banks became so big, why that leads to macroeconomic problems, and how consumers get trampled (answer: credit cards, issued by big banks; p.6).  He supports a resolution authority that would help deal with some situations, but also says (p.9):

“To those who say that some firms are too big to fail, I wholeheartedly agree that some are too big.  However, these firms can be unwound in a manner that does not cause irreparable harm to our economy and financial system but actually strengthens it for the long run.”

Mr. Hoenig is, if anything, a little too polite.  There is no evidence that huge banks, at their current scale, provide any social benefit.  When these same banks were much smaller, in dollar terms and as a percent of the economy, the global economy functioned no worse than today.

Mr. Ackermann and his colleagues are pursuing a purely self-serving line.  Reasonable centrist opinion is turning against them.  Either the big banks need to shrink voluntarily or they will potentially face consequences that they cannot control.

Building on ideas from the Kansas City Fed, the Bank of England, the UK Financial Services Authority, and the European Commission, the consensus is moving towards the view that state-supported banking (i.e., operating through implicit guarantees on Too Big To Fail banks) constitutes an unfair form of protectionism.  Financial services in this guise do not currently fall within the remit of the World Trade Organization, but it would be a simple matter to extend its mandate in this direction.

In any reasonable judicial-type process, involving relatively transparent weighing of the evidence, Mr. Ackermann would be most unlikely to prevail.

By Simon Johnson

Last weekend Yves Smith posted a story of a family that was down on their luck and struggling with high credit card bills, including plenty of fees. Yesterday she posted a follow-up. Apparently the story triggered a wave of vindictive snobbery from commenters. Here’s one example:

“Sounds like someone doesn’t know how to manage their money. I would bet they are making car payments and eat fast food at least 3 times a week. Probably have cable T.V. and deluxe cell phone plans. They probably get a new car like every two years. What happened to her reenlistment bonuses?”

Here is Yves’s response:

“I think quite a few readers owe her an apology. But I am also sure those readers are so locked into their Calvinist mindset that they will find some basis for criticizing this family. Some people seem constitutionally unable to admit that success and prosperity are not the result of hard work alone.”

First, I want to agree completely. There is the obvious fact that a person’s income as an adult is highly correlated with his or her parents’ income. (There was a recent debate about why in the blogosphere, but as far as I know no one contesting that this was the case.) But beyond that, we all owe a tremendous amount of whatever fortune we have to luck, pure and simple. Where would Bill Gates be if IBM hadn’t decided to outsource development of the operating system for the first IBM PC? Rich, no doubt, but $50 billion rich? I have worked hard at enough things, and failed at enough things, and succeeded at few enough things, to know how much luck is involved.

Second, I want to go beyond that to another point that seems obvious to me, but that some will probably find controversial. Even if differences in outcomes were entirely due to differences in abilities and effort (which they’re not) — would that make it OK? I think most people would say that it’s fine for smart people to make more money than other people. But why? Why are smart people any more deserving than anyone else? It’s true that in many jobs being smart can make you more productive and valuable, and as a result for many high-paying jobs being at least somewhat smart is a prerequisite. But the fact that a capitalist economy functions this way doesn’t make it morally right that the “winners of the genetic lottery” (a phrase I picked up from some basketball announcer talking about Tony Parker) have better outcomes than the losers.

Surely at least people who work hard deserve to do well. In the hierarchy of American moral virtues, hard work must be right at the top. But I’m not convinced of that, either. The ability to work hard is something that you either inherit from your parents or that you develop in your early childhood as a function of the environment around you. Either way, whether or not you have it is as much a matter of luck as is your IQ. Again, it’s obvious that working hard increases your productivity and therefore the wages you will be paid, all other things being equal. A small part of that differential seems “deserved,” since you are forgoing leisure for work. But the differential goes far beyond that. For example, doctors don’t just make more money than other people to compensate them for studying hard in school and working 36-hour shifts in residency; studying hard and 36-hour shifts are hurdles to clear in order to become a doctor and make a lot of money (if you’re a specialist, that is — some people do go through all the work and then make comparatively little).

Take me, for example. I’m smart and hard-working. I don’t know if it’s because of my genes, or because my parents brought me up right. But whatever the cause, I didn’t do anything to become smart or hard-working. And that’s the reason why I was able to go to good schools, get a good first job, and make more money than the average person, at least for a few years there (before quitting to go to law school). When I was young and frankly immature, being smart gave me a sense of entitlement. Now I just feel sort of lucky (“sort of” because I’ve learned that there are many more important traits than intelligence).

I’m willing to acknowledge that morality simply isn’t a factor when it comes to compensation. Seen from a utilitarian perspective, whether hard-working people deserve more than other people is a distraction. The key issue is that to maximize output in a more or less free market system, it has to be that way, since labor is supposed to be paid its marginal product. But there are still two implications of realizing that everything — even your initial endowments — is a matter of chance, not something you deserve.

The first is that you shouldn’t look down on other people (1) because their parents weren’t as rich as yours, or (2) because they aren’t as smart as you, or even (3) because they don’t work as hard as you. I think most people agree with (1); I think you should agree with (2) and (3), too.

The second is that the moral argument should be on the side of redistribution. I am willing to listen to utilitarian arguments against redistribution (e.g., high marginal tax rates reduce the incentive to work, blah blah blah blah blah); I may not agree with them, but they are a plausible position. However, I have little patience for the idea that rich people deserve what they have because they worked for it. It’s just a question of how far back you are willing to acknowledge that chance enters the equation. If you are willing to acknowledge that chance determines who you are to begin with, then it becomes obvious (to me at least) that public policy cannot simply seek to level the playing field, because that will just endorse a system that produces good outcomes for the lucky (the smart and hard-working) and bad outcomes for the unlucky. Instead, fairness dictates that policy should attempt to improve outcomes for the unlucky, even if that requires hurting outcomes for the lucky. But given that society is controlled by the lucky, I’m not holding my breath.

Update: I want to respond to a comment below by Markel. He accuses me of slipping meritocracy in through the back door with the assumption that income is correlated with intelligence and work effort. I think he’s right. The point I wanted to make is that even if income is correlated with intelligence and work effort, that isn’t necessarily a good thing. I think he’s saying that the premise itself may be wrong, and I agree it’s not something we should assume without support. I wanted to assume it in the rhetorical sense, as in “even if we assume …” I shouldn’t have implied that it is a matter of fact.

By James Kwak

The WSJ reports (on-line): “The U.K.’s top treasury official Sunday said the government is starting a process to rebuild the country’s banking system, likely pressing major divestments from institutions and trying to attract new retail banks to the market.”  The British style is typically understated and policymakers always like to play down radical departures, but this is huge news.

Pressure from the EU has apparently had major impact – worries about unfair competition through subsidizing “too big to fail” banks are very real within the European market place.  Also, strong voices from within the Bank of England have helped to move the consensus.

The US position on protecting everything about our largest banks is starting to look increasingly isolated and out of step with best practice in other industrialized countries.  Time to start planning for the break-up of Citigroup.

By Simon Johnson

From a Washington Post article on proposed legislation to regulate overdraft fees:

“Rep. Spencer Bachus (R-Ala.) said he avoided overdraft fees with a credit line and asked if many of the problems could be eased with consumer education.”

Good on you, Spencer. You have a credit line — which many of your constituents can’t get — and you have it linked to your checking account — which many of your constituents wouldn’t even know how to ask for.

Nessa Feddis of the ever-helpful American Bankers Association added that “most consumers can easily avoid the fees by keeping track of their balances.” (That’s a quote from the Post article describing her testimony, not from her testimony itself.) Hear that everyone? Keep track of your balances, and just in case, get a credit line and link it to your checking account. Problem solved.

The people who are financially sophisticated already know how to track their balances and turn off overdraft protection if they don’t want it. They are not the people that financial regulation is supposed to serve. You can’t discharge your duty as a representative of the people just by wishing that the people were more like you.

By James Kwak

“Our distinctiveness is we connect the world better than anyone else. We have a great capability of building a business around that. And we are in the process of building a culture around that.”

That’s Vikram Pandit on his company, Citigroup, as reported in The New York Times. What does it mean? Your guess is as good as mine.

What does it mean to “connect the world?” Sure, Citi is in a lot of places. But it is largely a retail bank — you know, the kind that you go to on the corner to take money out of your ATM. Most of its customers don’t move around the world very much. How do you “build a business” around connecting the world? This isn’t Cisco we’re talking about. And how do you “build a culture” around connecting to the world? To build a culture, you need to put together a group of people who understand the world, approach problems, and treat each other in a similar way. A new slogan won’t do it.

CEOs do have to speak in vague platitudes occasionally, but note that this was in an interview with reporters who were writing a feature article about the challenges facing Citigroup.

What Citigroup needs is a strategy. I can’t believe I’m saying this; after working at McKinsey, I thought that “strategy” was by far the most overused word in business. But what I mean is it needs some kind of story about what its customers need and what it can do well (better than its competitors), and that story has to somehow relate to what it is today. Think Lou Gerstner in the 1990s focusing IBM on services, or Larry Ellison deciding he would just buy all of his competitors and be done with it. If you’re making money, people will overlook the fact that your company doesn’t make any sense; if you’re struggling, like Citi is, they won’t.

Without such a story, it’s just a tangled mess of bad acquisitions that have no reason to be together. Now, the usual course of action in situations like this is to try to come up with a story that somehow justifies all the various bits and pieces, which gives you a story that is so weak as to be meaningless. The better answer is to come up with a story first, and then reshape the company to support that story. But that’s hard work.

Instead, a year after the crisis that would have put it out of business without extraordinary government assistance, instead of a strategy, all Citi has is a pro forma financial statement: the arbitrary division between “Citicorp” and “Citi Holdings.” As other people observed at the time of the split, there was no sound logic for how the company was split up. For example, North American retail banking and credit cards are on one side, but mortgages, auto loans, and student loans are on the other. So their plan is to run a retail bank that doesn’t lend money to households? Oh right — they’ll take the deposits and invest them in CDOs.

By James Kwak

As bankers’ pay, at least for the fortunate ones at Goldman and JPMorgan, returns to pre-crisis heights, a paper by Thomas Philippon and Ariell Reshef is becoming everyone’s favorite citation. The paper, “Wages and Human Capital
in the U.S. Financial Industry: 1909-2006,” got a first wave of attention from Paul Krugman, Martin Wolf, and Gillian Tett back in April (see Philippon’s web page for links). It’s also the subject of Justin Fox’s column in Time; see Fox’s blog for links to other discussions. (I also cited the paper in my ramblings provoked by Calvin Trillin.) The earlier references were mainly for Philippon and Reshef’s finding that pay in the financial sector correlated strongly and negatively with the degree of regulation — pay was higher in both the 1920 and in the post-1980 period, and lower under the stricter regulatory system created during the Great Depression. More recent references, including Fox’s column, have focused on the idea that people in finance are overpaid.

Since most articles have just focused on the headlines, I’m sure Philippon and Reshef are going to be misquoted all over the Internet. For example, at least two articles focus on a figure of “30% to 50% of financial-sector pay” in ways that are not quite correct. So I’ll try to lay out what they actually say.

Section 1 (see Figures 1-3) lays out the facts. Jobs in the financial sector were more complicated and more mathematical, required more education, and were more highly paid both before 1930 and after 1980.

Section 2 asks why this happened. They regress relative education (the share of highly-educated people in the financial sector relative to the rest of the economy) and relative wage (the ratio of wages in the financial sector to wages in the rest of the economy) against several explanatory variables:

• the degree of information technology use in the financial sector
• the amount of financial innovation (represented by the number of patents)
• the amount and complexity of corporate finance activity (represented by the share of IPO activity and the amount of credit risk)
• the amount of deregulation (interstate banking, Glass-Steagall, etc.)

Not all regressions use all explanatory variables, but the results (Tables 3 and 4) are consistent: deregulation is the only explanatory variable with a strong significant effect on both relative education and relative wages. In Table 3, for example, “deregulation alone accounts for 90% of changes in education and 83% of changes in wages.” Patents and IT intensity affect relative education but not relative wages; indicators of corporate finance activity affect wages but not education.

Now, none of this so far implies that people in finance are not worth their higher salaries. Deregulation could have created an environment in which the productivity differential between higher- and lower-skilled people became higher in finance than in other industries, making them more valuable in finance than elsewhere. Section 3 analyzes this issue. Figure 7 shows that, since the mid-1980s, the earnings of people in finance have shot up relative to the earnings of engineers (outside finance), even with the same level of education.

Figures 10 and 11 are based on the concept of a “benchmark” wage for finance. This is the wage that you would expect people in finance to get based solely on their relative education level (which we know went up after 1980), the skill premium (the amount that more highly-skilled people earn throughout the economy, which has also gone up since 1980), and the relative risk of unemployment (if you are more likely to be fired, you should be paid more to compensate). Figure 10 shows that given all this, you would have expected finance salaries to go up about 20% relative to the rest of the economy since 1980, but in fact they have gone up about 65%. The excess wage (Figure 11) — the difference between the amount people in finance make and the amount you would expect them to make — reached about 0.4 this decade; that means that if the average American is making $100, you might expect people in finance to make $125 (based on education, skill premium, and unemployment risk), but instead they are making $165.

The last set of regressions attempts to determine whether the excess wage in finance is due to characteristics of individuals in finance that are not observable in the previous regression. They do this by looking at the Census Bureau’s Current Population Survey, which is an individual-level sample. They determine that over the entire sample period (1967-2005), even after controlling for individual characteristics, working in finance is worth a 4.4% wage premium (Table 5; 8.3% for people with post-graduate education). Looking at specific time periods (Table 6), the wage premium only appears in 1986; from 1986 through 2005 it averages 6.0%. Comparing these wage premiums to the excess wage for the industry as a whole, they conclude that 30-50% of the excess wage is not due to differences in ability, but represents pure rents.

Note that the wage premiums calculated here cannot be compared to the excess wage in Figure 11, because Figure 11 is estimated using industry-level data, and the estimates in Tables 5-6  use the CPS, which suffers from top-coding (incomes are reported in categories, and there are no categories for the super-rich). My interpretation is that Figure 11 is the best way to see the size of the excess wage, since it doesn’t suffer from top-coding; Tables 5-6 are primarily useful for showing what proportion (30-50%, according to Philippon and Reshef) of that excess wage cannot be explained by differences between individuals.

So note in particular that the 30-50% number in the paper does not refer to the wage premium of people in finance; it is the proportion of the wage premium that cannot be otherwise explained. The excess wage itself depends on how you measure it. In Figure 11 (difference between finance wages and what finance wages would be expected to be based on education, skill premium, and unemployment risk) it gets up to 40%, but only in the last few years.

In any case, it’s clear that people in finance make more than people not in finance, and that you can’t explain it away just by saying they are more educated or their jobs are more risky. Now in one sense the defenders of high Wall Street pay are correct: people are probably getting roughly what they could make if they walked across the street and went to another bank. But that doesn’t answer the question of whether the whole industry is making a mistake and transferring wealth to employees that should go to shareholders.

By James Kwak

Yesterday morning I testified to a Joint Economic Committee of Congress hearing (update: that link may be fragile; here’s the JEC general page).  The session discussed the latest GDP numbers, the impact of the fiscal stimulus earlier this year, and whether we need further fiscal expansion of any kind.

I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but growth remains fragile in the United States because of problems in our financial sector.  While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems head on (e.g., lack of capital, distorted incentives, skewed power structure). 

We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, growth can resume quickly as the real exchange depreciates.  The idea that we necessarily are in a “new  normal” scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the “too big to fail” banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.

The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008).  But a further broad stimulus at this time is not warranted and the first-time homebuyers tax credit should be phased out.  We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges. 

Like all industrialized countries, we also need to look ahead to “fiscal consolidation” in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare).  The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.

My written testimony (with some small updates indicated) is below (pdf version).  This is now our revised Baseline Scenario.

Main Points

1. The world economy is experiencing a modest recovery after near financial collapse this spring.  The strength of the recovery varies sharply around the world: 

a. In Asia, real GDP growth is returning quickly to pre-crisis levels, and while there may be some permanent GDP loss, the real economy appears to be clearly back on track.  For next year consensus forecasts have China growing at 9.1% and India growing at 8.0%; the latest data from China suggest that these forecasts may soon be revised upwards.

b. Latin America is also recovering strongly.  Brazil should grow by 4.5% in 2010, roughly matching its pre-crisis trend.  We can expect other countries in Latin America to recover quickly also. 

c. The global laggards are Europe and the United States.  The latest consensus forecasts are for Europe to grow by 1.1% and Japan by 1.0% in 2010, while the United Sates is expected to grow by 2.4% (and the latest revisions to forecasts continue to be in an upward direction).  Unemployment in the US is expected to stay high, around 10%, into 2011.  [Update: the latest quarterly GDP data do not make us want to revise this view]

2. The current IMF global growth forecast of around 3 percent is probably on the low side, with considerably more upside possible in emerging markets (accounting nearly half of world GDP). The consensus forecasts for the US are also probably somewhat on the low side.

3. As the world recovers, asset markets are also turning buoyant.  Recently, residential real estate in elite neighborhoods of Hong Kong has sold at $8,000 US per square foot.  A 2,500 square foot apartment now costs $20 million.  Real estate markets are also showing signs of bubbly behavior in Singapore, China, Brazil, and India. 

4. There is increasing discussion of a “carry trade” from cheap funding in the United States towards higher return risky assets in emerging markets.  This financial dynamic is likely to underpin continued US dollar weakness.

5. One wild card is the Chinese exchange rate, which remains effectively pegged to the US dollar.  As the dollar depreciates, China is becoming more competitive on the trade side and it is also attracting further capital inflows.  Despite the fact that the Chinese current account surplus is now down to around 6 percent, China seems likely to accumulate around $3 trillion in foreign exchange reserves by mid-2010.

6. Commodity markets have also done well.  Crude oil prices are now twice their March lows (despite continued spare capacity, according to all estimates), copper is up 129%, and nickel is up 103%.  There is no doubt that the return to global growth, at least outside North America and Europe, is already proving to have a profound impact on commodity markets.

7. Core inflation, as measured by the Federal Reserve, is unlikely to reach (or be near to) 2% in the near future.  However, headline inflation may rise due to the increase in commodity prices and fall in the value of the dollar; this reduces consumers’ purchasing power. 

8. This nascent recovery is partly a bounce back from the near total financial collapse which we experienced in the Winter/Spring of 2008-09.  The key components of this success are three policies. 

• First, global coordinated monetary stimulus, in which the Federal Reserve has shown leadership by keeping interest rates near all time lows.  Of central banks in industrialized countries, only Australia has begun to tighten. [Update: and Norway, obviously affected by rising oil prices]
• Second, global coordinated fiscal policy, including a budget deficit in the US that is projected to be 10% of GDP or above both this year and next year.  In this context, the Recovery Act played an important role both in supported spending in the US economy and in encouraging other countries to loosen fiscal policy (as was affirmed at the G20 summit in London, on April 2^nd, 2009).
• Third, after some U-turns, by early 2009 there was largely unconditional support for major financial institutions, particularly as demonstrated by the implementation and interpretation of the bank “stress tests” earlier this year.

9. However, the same policies that have helped the economy avoid a major depression also create serious risks – in the sense of generating even larger financial crises in the future.

10.  A great deal has been made of the potential comparison with Japan in the early 1990s, with some people arguing that Japan’s experience suggests we should pursue further fiscal stimulus at this time.  This reasoning is flawed.

11.  We should keep in mind that repeated fiscal stimulus and a decade of easy monetary policy did not lead Japan back to its previous growth rates.  Japanese outcomes should caution against unlimited increases in our public debt.

12.  Perhaps the best analysis regarding the impact of fiscal policy on recessions was done by the IMF.  In their retrospective study of financial crises across countries, they found that nations with “aggressive fiscal stimulus” policies tended to get out of recessions 2 quarters earlier than those without aggressive policies.  This is a striking conclusion – should we (or anyone) really increase our deficit further and build up more debt (domestic and foreign) in order to avoid 2 extra quarters of contraction?

13.  A further large fiscal stimulus, with a view to generally boosting the economy, is therefore not currently appropriate.  However, it makes sense to further extend support for unemployment insurance and for healthcare coverage for those who were laid off – people are unemployed not because they don’t want to work, but because there are far more job applicants than vacancies.  Compared with other industrial countries, our social safety net is weak and not well suited to deal with the consequences of a major recession.

14.  The first-time home buyer tax credit should be phased out.

15.  GMAC should not receive a further infusion of government money.  It should be turned down for any kind of additional bailout; as with CIT Group earlier in the summer, this would force a negotiation with creditors and some losses for bondholders (most likely through a pre-packaged bankruptcy process).  This would not cause a general financial panic; probably it would actually strengthen the overall process of economic recovery, as it would move incentives in the right direction.

16.  The lack of skills among people who did not complete high school or who did not attend college is a critical longer term problem in the United States.  The impact of the recession will exacerbate the problems in this regard.  We should respond by further strengthening community colleges, allowing them to offer more vocational skills classes and to provide a viable way for more people to work their way into four-year colleges.

17.  America is well-placed to maintain its global political and economic leadership, despite the rise of Asia.  But this will only be possible if our policy stance towards the financial sector is substantially revised: the largest banks need to be broken up, “excess risk taking” that is large relative to the system should be taxed explicitly, and measures implemented to reduce the degree of nontransparent interconnectedness between financial institutions of all kinds.

The remainder of this testimony reviews current U.S. macroeconomic issues in broad terms, assesses the lessons of Japan’s experience in the 1990s, and make proposals for further essential reform (both fiscal and financial).

Current U.S. Issues

To be a strong global leader in the future, America needs to generate an environment where entrepreneurship, technological innovation, and immigration ensure that the nonfinancial private sector can continue to propel the US economy. 

It is premature to argue that the US economy has stumbled into a “new normal” paradigm that involves slower growth.  The factors that drove our growth over the last 150 years, particularly entrepreneurial startups and the commercialization of invention, remain despite the crisis.  Indeed, these drivers of growth may become even stronger in the future, if we can reduce the wasteful financial sector activities that grew since the 1980s (and really flourished over the past decade) and allocate resources to more productive activities in the future.  

America needs a new framework to harness that growth.   That framework needs to address the following problems with our current economic structure.

Problem 1:  With the recent financial sector bailouts, we have sent a simple message to Americans: The safest place to put your savings is in a bank, even if that bank is so poorly managed, and has such large balance sheet risks, that just six months ago it almost went bankrupt.

Despite being near to bankruptcy six months ago, Bank of America credit default swaps now cost only 103 basis points per year to protect against default, and the equivalent rate for Goldman Sachs is a mere 89 basis points.  Goldman Sachs is able to borrow for five years at just 170 basis points above treasuries.  This is not a sign of health; rather it indicates the sizable misallocation of capital promoted by current policies.  American’s leading nonfinancial innovators would never be able to build the leverage (debt-asset ratio) on their balance sheet that Goldman Sachs has, and then borrow at less than 2% above US treasuries.  The implicit government guarantee is seriously distorting incentives.

Problem 2:  We have not changed the incentive structures for managers and traders within our largest banks.  Arguably these incentives are more distorted than they were before the crisis. So the problems of excessive risk taking and a new financial collapse will eventually return.  Financial system incentives are a first-order macroeconomic issue, as we have learned over the past 12 months.

Today bank management is strongly incentivized to take large risks in order to raise profits, increase bank capital, and pay large bonuses to “compete for talent”.  Since they have access to a pool of funds effectively guaranteed by the state through being “too big to fail”, there is the potential to make large profits by employing funds in risky trades with high upside.  Such activities do not need to be socially valuable, i.e. it could be that the expected return on the investments is negative, but as the downside has limited liability, the banks can go ahead.

Problem 3:  We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking.  The proposals currently proceeding through Congress are unlikely to make a significant difference.

Problem 4:  The policy response to this crisis, with very low interest rates and a large fiscal stimulus, is merely a larger version of the response to previous similar crises.  While this was essential to stop a near financial collapse, it reinforces the message that the system is here to stay.  

Problem 5:  The public costs of this bailout are much larger than we are accounting for, and people who did not cause this crisis are ultimately paying for it.   Taxpayers and savers are the big losers each time we have these crises.  We are failing to defend the public purse.  

Our financial leaders have emphasized that our banks are well capitalized, and no new public funds are likely to be needed to support them.  This is misleading.  The current monetary stance is designed to ensure that deposit rates are low, and the spread between deposit rates and loan rates is high.   This is a massive transfer of public funds to the private sector, and no one accounts for that properly. 

It is striking that the Chairman of the Federal Reserve himself, in a recent speech, stated that no more public funds were needed to bail out banks.  His institution continues to provide massive transfers to the banking system through loose credit and low interest rate policy.  That credit could instead go to others; the Federal Reserve has chosen to transfer those funds to banks.  This policy was used in the past to recapitalize banks (e.g., after 1982), but we have now a very different financial sector – with much more capacity to take high risks and a greater tendency to divert profits into large cash bonuses.

Today, depositors in banks earn little more than the Federal Funds rate and are effectively financing our financial system.  We are giving them very low returns on their savings because the losses in the financial system were so large in the past.  This is essentially public money – it is the pensioners, elderly people with savings, and other people who have no involvement in the financial system, that are being required to suffer low returns to support the banks. 

We Are Not Japan

After the bursting of its real estate bubble, at the end of the 1980s, Japan faced a serious problem in its financial sector.  This fact has inspired many people to look for parallels with the current US situation, and – in some cases – to draw the implication that we should pursue further large-scale fiscal stimulus today.

There is a cautionary tale to be learned from the Japanese experience – on the need to promote, rather than to prevent, appropriate macroeconomic adjustment.  But this does not encourage a further expansion in the budget deficit at this time.

The property bubble and general credit bubble in Japan were actually much larger than what we recently experienced in the U.S.  The implied price of the land in the Emperor’s Palace, in central Tokyo, was worth more than all of California (or Canada) at its peak.  Land prices collapses and never recovered.  US house and land prices never got so far out of line with the earning capacity of homeowners.

The Japanese stock market rose to price-earnings ratio of around 80 (depending on the exact measure), also as a direct result of the credit bubble.  The US did not experience anything similar in the last few years.

Japan was – and largely remains – a bank-based finance system.  And their nonfinancial corporate sector was generally much more indebted (often using borrowed money to buy land, but also over-expanding their manufacturing capacity) than was the case in the US.  Total Japanese corporate debt was 200 percent of GDP in 1992 – more than double its value in 1984. The implication was a long period of disinvestment and saving by the corporate sector – in fact, this change from the 1980s to 1990s explains most of Japan’s increased current account surplus after the crisis.  Since Japanese corporates had accumulated too much capital, they exhibited low returns in the post-crisis period.  The US has strong bond and equity markets, and our corporate sector is not heavily indebted – so the cash flow of the nonfinancial sector should bounce back strongly.

In contrast to Japan, the US consumer has much more debt and saves less – in fact, on average over the past decade, the our household sector has saved roughly nothing (partly due to the effects of rising wealth, from higher house prices).  This sector will be weak in the US.  In contrast, in Japan during the 1990s there was no significant increase in household saving (and thus no contribution from this sector to their current account surplus.)

The obvious solution for any country in the situation faced by the US is to let the economy adjust, which implies and requires that the real exchange rate depreciates – so our exports go up, our imports (and consumption) go down.  This is a level adjustment downward in our GDP and standard of living, but then growth will resume on this new basis.

In contrast, Japan did not grow largely due to their over-investment cycle (in real estate, but also plant and equipment).  This created a much more difficult adjustment process, which worked for manufacturing primarily through depreciation of installed capacity and a gradual movement of production off-shore (e.g., to China and other Asian countries).

In addition, another major cause of Japan’s poor performance was its demographics, and the relatively lackluster growth of its trading partners in Asia due to the Asian crisis.  With its working population peaking in 1995, Japan lost a major driver of growth.  The country still has strong enterprises and decent productivity growth in the manufacturing sector, which allows them to grow.  But the pace is naturally slower than when they were “catching up” through the 1980s.  During the last ten years Japan’s has grown around the same pace as some of the continental European nations with better but also poor demographics, such as Italy and Germany (the comparison is from Q1 1998 to Q1 2008).

The Japanese policy reaction was to run budget deficits and maintain very loose monetary policy for over a decade, in an attempt to stimulate the economy and obviate the need for painful adjustment (including job losses, recognizing losses at major banks, and properly recapitalizing those banks).  Today Japanese gross debt to GDP is at 217%, and it is still rising (net debt, even on the most favorable definition, is over 110% of GDP).  The working population of Japan is now declining quickly, and so those people that are required to pay back the debt face ever rising burdens.  There is a real risk that Japan could end up in a major default, or need a large inflation, to erode the burden of this debt since their current path is clearly unsustainable. 

Japan’s policy approach from the 1990s – repeated fiscal stimulus and very easy money – is not an appealing model for the U.S. today.  All dynamic economies have a natural adjustment process – this involves allowing failing industries to decline, and letting new businesses develop where there are new opportunities. 

In fact, while Japan hesitated for over a decade to let this process work (particularly protecting the insiders at their major banks), it has finally moved in this direction.  Unit labor costs in Japan have declined sharply over the last ten years, helping making the country a more competitive exporter.  The forced recapitalization of some major banks, at the end of the 1990s, was also a move in the right direction.

The process of deflation – spoken of with terror by some leading central banks around the world today – actually makes industry more competitive, and while there are negative aspects to it (particularly if the household sector is heavily indebted, as in the US), the modest price declines seen in Japan are not a disaster.  In fact, real GDP per worker in Japan – annualized over the past 20 years – has increased by 1.3 percent per annum; while the comparable number in the US is 1.6 percent.  Over the past 10 years, real GDP per worker (annualized) increased by 1.3 percent in both Japan and the US – and now it turns out that much of the GDP gains in the US financial sector may have been illusory.

The Japan-US comparison is not generally compelling, particularly as Japan ran a current account surplus even during its destabilizing capital inflows of the 1980s.  The current US experience more closely matches the experience in some emerging markets, which have in the past run current account deficits, financed by capital inflows – with the illusion that this was sustainable indefinitely.

The long and hard experience of the International Monetary Fund (IMF) with such countries that have “lived beyond their means” – or over-expanded in any fashion – is that it is a mistake to try to prevent this process of competitive adjustment, i.e., bringing spending back into line with income, which implies a smaller current account deficit or even a surplus.  The adjustment can be cushioned by fiscal policy – and here the IMF has changed its line over the past few years, now offering sensible support for this approach.  But attempting to postpone adjustment with repeated fiscal stimulus is almost always a mistake.

Japan did not want to force its corporate sector to adjust (i.e., in the sense of going  bankrupt and renegotiate its debts), so it offered repeated stimulus.  As a result, it has become stuck with a “permanent” fiscal deficit program which is now threatening their survival as a global economic power, and will – regardless of the exact outcome – burden future generations for decades. 

Some analysts further claim that Japan’s early withdrawal of stimulus is a major factor explaining why they have not returned to robust growth rates.  It is true that Japan introduced a new VAT tax in April 1997 not long before the Asian Financial Crisis began, and the Bank of Japan raised interest rates by 25 basis points in August 2000.  Subsequent to these changes the economy slowed down. 

However, each of these measures were relatively small.  The Bank of Japan reversed course on interest rates quickly, and a negative turn in the economy was surely already in the cards – this occurred at the same time as the global economy slowed down, and a great stretch to argue that a 25 basis point move could explain the poor performance of Japan’s economy for years or decades subsequent.

As long as there are not major adverse shocks from the rest of the world, the US will experience higher savings, a fall in consumption, a recovery in investment, and an improvement in the its net exports (so the current account deficit will become smaller, or stay at its current level even as the economy recovers).  Growth will resume, driven by demographics, technical progress, and entrepreneurship.  The high level of unemployment also implies that rapid growth will be fuelled by willing workers, subject to the right skills being available.

Proposals For Change

The main threats to the recovery scenario come from the financial system, which has developed serious and macro-level pathologies over the past two decades.

We have weak bank regulation and supervision.  Politically we can’t let banks fail: they bend or lobby to change the rules in order to grow big, and then we bail them out. 

New theories of deflation and zero interest rate floors attempt to explain why we need unprecedented large bailouts – with the experience of Japan and the Great Depression of the 1930s offered as partial justification.  More likely, we are on an unsustainable fiscal path with the potential for new financial bubbles.

The following changes should be priorities.

1. Reduce the impact of financial sector lobbying on bank regulation and supervision.  Today the US Treasury is filled with former finance sector workers in key positions responsible for financial sector reform and bailouts.  This is too large a conflict of interest.  We need to close the revolving door between government and the financial sector.

2. Put far greater regulation and closer supervision on the large remaining banks that are clearly too big to fail.  These should be broken up into much smaller pieces, so we have a more competitive system. 

• When major financial institutions request additional help from the government, such as GMAC, they should be turned down.  This would force their bondholders to take a loss and lead to better incentives for the future.  It is highly unlikely that it would cause a major financial panic.  The financial system is experiencing a sharp bounce back more broadly and GMAC can likely arrange a pre-packaged bankruptcy that would actually allow its debt to rise in value.
• Banks can syndicate if they need to do large transactions. This is actually what they do for most capital raising transactions. 
• Banks should draw up “living wills” and raise additional capital as they become larger relative to the system.

3. We should also toughen our monetary policy to send a clear message that we will not maintain a pro-cyclical monetary policy which bails out banks at the end of each crisis.  The cross-liabilities on banks’ balance sheets should be reduced as far as possible to lower the risks involved with letting one fail. By doing this, we would free the hands of those running our monetary policy to take tougher actions to stop the next bubble. 

4. We need to address the inequality driven by our bailouts as a gesture to show that we will defend the public purse beyond the simple accounting in the budget. 

• Increasingly, there is discussion of taxing “excess risk taking” (reflected in high profits and bonuses) in the financial sector, particularly if that is large relative to the system.  The terms in this debate have not yet been clearly defined and this initiative could go in the wrong direction.  But we should recognize that mismanagement at major banks has created huge negative externalities both for the financial system and for the economy as a whole.  Taxing activities that generate such externalities is entirely appropriate in other sectors, and the same reasoning is likely to be applied for banking also.
• In addition, we should also require that Goldman Sachs, GMAC, and other non-banks (i.e., those operating without deposit insurance) with access to the Federal Reserve’s window pay a substantial long term annual fee to compensate taxpayers for that access.  This is a valuable insurance policy which they have – at this point – been given for free.

5. We should withdraw the fiscal stimulus over 5 years and aim for fiscal consolidation, including Medicare costs, at that time.  We should use extra spending to target specific issues that will help people improve their skills, but wind down the temporary public works programs that build jobs in the public sector. 

6. All industrialized countries need to make a substantial fiscal adjustment over the medium-run, in order to stabilize public debt levels.  The size of this adjustment depends on assumptions (and policies) regarding longer-run medical costs as the population ages and medical technology becomes more expensive.  The US and almost all other members of the OECD most likely require a fiscal adjustment in the range of 4-8 percentage points of GDP.  In that context, further unfunded or nontransparent contingent public liabilities vis-à-vis the financial sector are untenable; the Japanese experience should be taken as a warning sign in this regard.

7. For the longer-run, we should focus on measures that improve skills for people with fewer years of formal education.  Supporting the expansion of community colleges and other practical skills training is the best way forward, although this will take some time to scale up.

By Simon Johnson, Peter Boone, and James Kwak

Ben Bernanke, chairman of the Federal Reserve, has stayed carefully on the sidelines while a major argument has broken out among and around senior policymaking circles: Should our biggest banks be broken up, or can they be safely re-regulated into permanently good behavior? (See the recent competing answers from WSJ, FT, and the New Republic).

But the issues are too pressing and the stakes are too high for key economic policymakers to remain silent or not have an opinion.  On Cape Cod last Friday, Mr. Bernanke appeared to lean towards the banking industry status quo, arguing that regulation would allow us to keep the benefits of large complex financial institutions.

Note, however, that Bernanke’s quote making this point in the NPR story (at the 45 second mark) is from his spoken remarks; the prepared speech does not contain any such language.  And Mr. Bernanke is wise to be wary of endorsing the benefits of size in the banking sector – the evidence in this regard is shaky at best.

There are three main types of evidence: findings from academic research on the returns to size in banking; current and likely future policy in other countries; and actual practices in the banking industry.

First, while academic research is not always the primary driver of policy choices, it is relevant when we can readily see the costs of big banks (in the crisis around us) but the supporters of those banks claim they bring important benefits.  In fact, the available research indicates that in the banking sector, economies of scale exist only up to a (relatively low) level of total assets, while economies of scope are elusive. The benefits from diversification across countries or lines of business are also small; moreover over the last few months we learned that correlations among different markets and asset classes increase rapidly during a crisis – thus reducing even more the benefits of diversification.  [See “Consolidation and efficiency in the financial sector: A review of the international evidence,” by Dean Amel, Colleen Barnes, Fabio Panetta, Carmelo Salleo; Journal of Banking & Finance 28 (2004) 2493–2519.  Note that one of the authors works at the Federal Reserve Board, and all four work in a central bank or ministry of finance.]

Second, policy in other countries matters because some fear that breaking up big US banks would somehow put us at a competitive disadvantage vis-à-vis big European or other banks.  But on this issue the European Commission spoke loudly this week – ordering the break-up of ING, and the presumption is that they will also soon put similar pressure on big UK banks.

Interpretations of this action vary – some see it as an implementation of competition policy, while others feel the Commission is (rightly) concerned about the unfair subsidies implicit in government ownership and support for large banks.  The Commission itself is being somewhat enigmatic, but the exact official motivation doesn’t matter – the important point is that the leading pan-European policy setting organization, which does not rush into decisions, has determined that whatever the benefits of size in banking, the public interest requires smaller banks.

Third, in terms of actual business practice, any big investment banking transaction is done with a syndicate or group of banks – there is sometimes a lead bank with a favored relationship, but that role is definitely shopped around. 

Take, for example, General Electric’s October 2008 share offering, in which there were seven lead managers.  Or look at the prominent Microsoft bond offering, which had Bank of America, Citi, JPM, Morgan Stanley as lead managers and Credit Suisse, UBS, and Wachovia as “joint lead” (in this context, “joint lead” is the junior partner).  If a nonfinancial corporate entity takes out a large bank loan, this is also shopped around and syndicated – even for medium sized companies – so as to divide up the risk. 

Similarly, if a company wants to do a foreign exchange transaction, it searches for offers and take the best deal.  It would be unwise to rely exclusively on one bank – they will naturally hit hard you in terms of higher fees. 

One area where banks benefit from size is in terms of being able to put their balance sheet behind a transaction – e.g., to get a merger done they may offer a bridge loan, with the real goal being to get merger fees.  Bigger banks with a large balance sheet have an advantage in this regard. However, this kind of risk taking is also what gets banks in trouble (e.g., in the 1997-98 Asian Financial Crisis).  In the past, both Morgan Stanley and Goldman Sachs did not have large balance sheets but still did well in mergers and acquisition. 

Goldman is an interesting case because it had $217 billion in assets in 1998 (that’s $270 billion in today’s dollars); it now has around $1 trillion.  Goldman was considered a strong global bank in the late 1990s.  Can it really be the case that the idea size for banks has risen so dramatically over the past decade?  (Lehman had $154 billion assets in 1998 and above $600bn when it failed). 

For derivatives (and other instruments) it’s important to have deep markets, but not necessarily big banks.  If you want to buy and sell stock you want a liquid market, and the same is true for derivatives. 

If you are a large oil company, and you want to hedge future risk, your choices are:

1.  Hedge with a “too big to fail” bank, because you know taxpayers will bail you out and these banks are subsidized by their government support, so they can give you a better price. 

2.  Or you can hedge with several banks to minimize counter party risk.  They then sell of some of the risk – taking take less risk themselves as they are small enough to fail.

If you were hedging you’d prefer the “too big to fail” system because it comes with a nifty subsidy.  But this is not what the Federal Reserve should be supporting – Mr. Bernanke may still come out in favor of markets-without-subsidies.

By Peter Boone and Simon Johnson

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

This guest post was submitted by David Moss, professor at Harvard Business School, author of When All Else Fails: Government As The Ultimate Risk Manager, and founder of the Tobin Project.

 As currently drafted, the Financial Stability Improvement Act of 2009 (released by the House Financial Services Committee on 10/27/09) contains several important elements for reducing systemic risk.  It aims (1) to identify systemically dangerous financial firms, (2) to apply heightened regulation to these firms, (3) to establish a stabilization system to prevent or quell panic during periods of systemic distress, and (4) to create a resolution mechanism that would wind down complex financial firms when necessary.  These could represent very important steps forward.

Unfortunately, these reforms may ultimately be undermined by one very significant weakness – the explicit requirement in the bill that the identification of systemically dangerous financial firms by federal regulators remain entirely secret, and never be revealed to the public.  This is the bill’s Achilles heel. 

The decision that there be “no public list of identified companies,” as the bill currently reads, stems from a belief that secrecy about the identity of these firms will limit moral hazard.  However, after more than a year of costly bailouts, the federal government’s implicit guarantee of major financial firms is, sadly, rock solid.  To try to make it magically disappear by refusing to name the most systemically dangerous firms not only won’t work, but will severely jeopardize the effectiveness of the regulation itself. 

To maintain the pretense of secrecy, the bill includes some very unfortunate compromises:

            ●    First, the bill does not require the systemic regulator to adopt a consistent (or universal) set of tough standards for all systemically dangerous firms, presumably to avoid compromising the secrecy surrounding these “identified” financial institutions.

            ●    Second, the desire to hide these firms’ regulatory status (as systemically dangerous) means that they cannot be assessed fees in advance to cover their share of a resolution or stabilization fund; instead, the bill envisions ex post assessments on a much larger pool of firms, including a great many that are not systemically dangerous.  (This would be like charging renters to cover the fire losses of homeowners.)

            ●    Third, the attempt to ensure secrecy requires that all of the regulators’ reports to Congress themselves remain strictly confidential, thus weakening – and perhaps crippling – the essential process of democratic oversight.

Perhaps most disconcerting, all of these compromises will most likely be for naught, since the desired secrecy seems almost impossible to achieve.  Virtually everyone already knows the identities of the most systemically dangerous firms; and, beyond that, leaks are inevitable.

Moreover, to the extent that secrecy was somehow maintained, it would leave the systemic regulator highly vulnerable to capture by the very financial institutions it was charged with regulating.  Just imagine how weak regulations would become if the regulated firms themselves were the only parties that could weigh in on a proposed regulation, since the regulatory process was required to be hidden from everyone else.

The proposed legislation has many strengths.  But without greater transparency, it will inevitably fall short – both in eliminating “too big to fail” financial firms and, most importantly, in preventing the next financial crisis.  To be successful, the final legislation must require the creation of a public list of all systemically dangerous financial institutions; and it must ensure that these firms are subjected to dramatically heightened regulation to control excessive risk taking.  In fact, the regulation of these firms must be so tough that they feel a strong incentive to slim down or break up in order to get off the list.  Such a vital public mission will never be achieved in the shadows.  (For more on this, see my recent piece on financial regulation in Harvard Magazine.)

 By David Moss