I don’t spend a lot of time trying to police the economic news media — Dean Baker and Brad DeLong are much better on that — but I found myself reading a two-week-old Newsweek column by Robert Samuelson that enraged me enough to type this out. (I read it on old-fashioned paper, but here’s the WaPo version.) The title of the WaPo version is “Could America Go Broke?” and here’s the last paragraph:

“Deprived of international or domestic credit, defaulting countries in the past have suffered deep economic downturns, hyperinflation, or both. The odds may be against a wealthy society tempting that fate, but even the remote possibility underlines the precariousness and the novelty of the present situation. The arguments over whether we need more ’stimulus’ (and debt) obscure the larger reality that past debt increasingly constricts governments’ economic maneuvering room.”

Deep economic downturns! Hyperinflation! “Precariousness and novelty of the present situation!” You’d think there was some actual reason to be afraid.

But not only does Samuelson provide no evidence that high debt levels lead to disaster, the evidence he does provide contradicts his alarmist conclusion. He says, “We have moved into uncharted territory and are prisoners of psychology. Consider Japan.” Then he considers Japan — and points out that even though Japan has the highest debt of any advanced economy, interest rates on Japanese debt have fallen to historically low levels. Somehow he says the “correct conclusion to draw” from the Japanese example is that “[major governments] can can easily borrow as much as they want until confidence that they can do so evaporates — and we don’t know when, how or whether that may happen.”

That’s not a conclusion from the Japanese example — that’s a truism that Samuelson asserted before the Japanese example and just repeated after it. (How we are on “uncharted territory” when Japan is already on that territory also escapes me.)

Samuelson doesn’t say anything that’s demonstrably false, because basically his column can be boiled down to this:

“If a government loses the ability to borrow money, bad things can happen. A government will lose the ability to borrow money when people are no longer confident that the government will pay them back. We don’t know when people will lose confidence. It may have something to do with the total amount of government debt, but then again it may not (see Japan).”

But that column is obviously not worth writing. So instead we get hyperinflation.

I’m not a fan of massive and increasing government debts in the abstract, forever. Who is? And there are real arguments to be made on this topic. But that’s not an excuse for empty rhetoric that serves no purpose. But wait — it does serve a purpose — the purpose of scaring people and politicians into not doing something about massive unemployment (because doing something might lead to hyperinflation, of course).

(After deciding to write this I realized that Dean Baker beat me to it by two weeks, but I think I’ve added onto what he had to say.)

By James Kwak

As everyone knows by now, Neil Barofsky, special inspector general for TARP, has a new report out on the decision by the Federal Reserve Bank of New York last Fall to make various AIG counterparties (primarily some very big banks with names you know) whole on the the CDS protection they had bought from AIG to cover their risk on some CDOs. The potentially juicy bit has to do with the Maiden Lane III transaction (New York Fed summary here).

There are a couple of details I can’t quite reconcile (for example, the Fed balance sheet shows initial funding of $29.3 billion, but everyone says Maiden Lane III paid $29.6 billion for the CDOs), but essentially it went like this. The banks had bought CDS protection on $62.1 billion of CDOs (some of those CDOs they owned — some they did not, meaning those were “naked” CDS*). As of November, the market value of those CDOs was $29.6 billion. At that point, the banks already held $35.0 billion in cash collateral from AIG to cover the difference. (If you have a derivatives contract with someone under which your counterparty may have to pay you a huge amount of money, you generally negotiate a term under which the counterparty has to give you money as the trade moves against him, to protect you from default. In this case, a lot of the collateral came from the $85 billion credit line the Fed gave to AIG in September — otherwise AIG would have gone bankrupt because of collateral calls.)

In the transaction (I’m working off the New York Fed summary), first AIG contributed $5 billion to Maiden Lane III and the New York Fed gave it a $24.3 billion loan. Then Maiden Lane III gave all $26.8 billion to the banks in exchange for the CDOs. (The banks accepted $26.8 billion because  they already held $35.0 billion in collateral; together that makes $61.8 billion — as I said, I can’t get $300 million to reconcile.) Then Maiden Lane III gave $2.5 billion right back to AIG (this is the amount by which AIG had overcollateralized). As part of the deal, the banks agreed to tear up the original CDS on the CDOs, so AIG couldn’t lose any more on the CDS (which, remember, are separate from the CDOs).

The controversy is not over paying $29.3 (or $29.6) billion for the CDOs, since that was the market price. The controversy is over whether AIG should have agreed to settle the CDS at 100 cents on the dollar (meaning that the banks get the difference between the face value of the CDOs and their current market value). Bloomberg reported a while back that prior to the government bailout, AIG had been trying to negotiate a settlement at 60-70 cents on the dollar, but that that portion of the term sheet was crossed out in the final agreement. The implication is that paying the swaps off in full was a back-door, off-the-books way of funneling cash to banks that we didn’t want to fail.

The argument for the NY Fed is that the banks had legal contracts that entitled them to the money. AIG might have been able to negotiate a haircut because it was going bankrupt and counterparties will take less money up front rather than risk getting even less in bankruptcy. However, once the government stepped in, it had no way to abrogate the contracts. The Agonist has a long post with much more detail than I have provided, arguing in conclusion that Federal Reserve Bank presidents are technocrats, and technocrats abide by the advice of their lawyers, which was almost certainly that AIG had to pay off the swaps in full. (He says the mistake was bailing out AIG in the first place back in September.)

Various people have argued, however, that the Fed could have negotiated a better deal. The Epicurean Dealmaker argues that, given the considerable powers of the Federal Reserve and the federal government in general, the banks could have been intimidated into accepting a modest haircut.

Robert Pozen, in his very worth reading book Too Big to Save?, says (p. 79) that AIGFP could have been forced into bankruptcy without putting the rest of AIG into bankruptcy; threatening to put AIGFP into bankruptcy would have provided the leverage to induce the banks to take a haircut. Lucian Bebchuk, a Harvard law professor, argued back in March that because AIG had guaranteed the obligations of AIGFP, this would constitute a default by AIG — but that wouldn’t affect AIG’s insurance subsidiaries, which could stand alone quite nicely (insurance companies get most of their money from customer premiums, not from debt).

I think that given the state of the world in November 2008, paying the banks off in full was definitely the easy choice — it’s always easier to abide by the contract and pay up, especially when you have very deep pockets. And the fact that it helped out the banks as well was probably seen as another argument for it, given the perceived need within the government to bolster the banks’ balance sheets by any means necessary.

* Apparently there is some controversy about this. In an interview, Representative Peter DeFazio said the following:

“Geithner would not answer my question when I said, ‘Were those naked credit default swaps by Goldman or were they a counter party?’ He said, ‘I will not answer that question.’”

From the New York Fed web site:

“AIGFP, the LLC and the New York Fed have entered into agreements with AIGFP’s credit derivative counterparties to terminate approximately $53.5 billion notional amount of credit derivatives and purchase the related multi-sector CDOs. Of these, CDOs with a principal amount of approximately $46.1 billion settled on November 25, 2008. Settlement on the remaining $7.4 billion is contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs and thereby settle with the LLC and terminate the related credit derivative contracts with AIGFP” (emphasis added).

By James Kwak

The Community Reinvestment Act is a law originally passed in 1977 that directed federal regulatory agencies to ensure that the banks they supervised were not discriminating against particular communities in making credit available.The onset of the subprime mortgage crisis triggered a flood of sloppy, lazy attacks on the CRA claiming that since the crisis was created by excess lending to the poor, and the CRA was intended to increase lending to the poor, the CRA must have caused the crisis. These arguments suffered from a mistaken premise (subprime lending had a modest negative correlation with income, but many subprime loans were used by the middle class to buy expensive houses in the suburbs and exurbs of California and Nevada) and a failure to check their facts (“Only six percent of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes.” — Randall Kroszner, former Fed governor appointed by President George W. Bush, in a Federal Reserve study that also found that subprime loan performance was no worse in CRA-covered zip codes than in slightly more affluent zip codes not covered by the CRA.)

Yesterday at a Cato Institute conference, Edward Pinto, chief credit officer at Fannie from 1987 to 1989 and currently a real estate financial services industry consultant (according to recent Congressional testimony), rolled out the new line. The new argument is a curious mirror image of the old argument (which Pinto himself may not have made): now the subprime explosion did not cause the housing bubble, but was caused by the housing bubble and … wait for it … the CRA caused the housing bubble, along with the affordable housing goals of Fannie and Freddie.

Before going further, it’s time for my favorite lesson on correlation and causality.

The idea that the housing bubble caused the explosion in subprime lending is not crazy. The worst excesses in mortgage lending happened in 2003-06, after housing prices had already reached historical highs. The idea is that with prices so high, lenders had to offer exotic mortgages (and stop checking for documentation) in order to make the houses affordable for new borrowers. (Of course, there should have been stronger safeguards against those exotic mortgages — consumer protection enforcement, better credit rating agencies, etc. — but that’s another topic.)

But the weirder part of the argument is that the CRA caused the housing bubble. A policy could push housing prices up by increasing the availability of credit in a way that increases borrowers’ buying power. However, that can only contribute to a bubble if (a) it increases the number of loans that cannot be paid off, making price rises unsustainable and (b) there is some continually-increasing aspect to the policy, without which prices should simply reset at a higher level.

Pinto gets into an argument with the Federal Reserve study (cited above) on the performance of CRA-covered loans, claiming that those loans are doing worse than the Fed claims; I can’t judge that without seeing something in more detail. But even so, there are a few missing elements to the causal chain. One is that the CRA should only have an effect in low-income communities, and unless the people buying houses in the Nevada desert were all people who had been priced out of low-income communities by the CRA, it’s hard to blame the real housing price craziness on the CRA. Another is that the CRA itself has provisions that say that lenders do not have to make loans that are unprofitable. A third is that if the CRA was forcing banks to make unprofitable loans, then you would expect the nonbank lenders to stay out of those market segments; in fact, we saw just the opposite.

Back in 2000, Cato had a different line on the CRA. Jeffrey Gunther wrote an article in a Cato journal arguing that the CRA should stand for “Community Redundancy Act” because competitive forces in the market made it unnecessary — lenders seeking profits would not discriminate against particular communities. Gunther cited subprime lending as an example of the type of profit-seeking innovation that made the CRA unnecessary. He noted exactly what CRA defenders argue today:

“If CRA were the driving force behind the recent increases in home-purchase lending in low-income neighborhoods, we would see evidence of a treatment effect. Lenders subject to the ‘CRA treatment’ [regulated banks] would have refocused their activity toward CRA objectives to a greater extent than lenders in the untreated control group [nonbank lenders]. However, there is little evidence of such a treatment effect. To the contrary, it was lenders in the control group that refocused their efforts in line with the mid-1990s boom in lending in low-income neighborhoods. In fact, lending in low-income neighborhoods grew faster than other types of lending at institutions not covered by CRA, whereas low-income lending grew at the same rate as other types of lending activity for CRA-covered lenders.”

Gunther’s optimism about subprime lending seems naive in hindsight, although it was shared by many prominent economists and policymakers from Alan Greenspan on down.

For the CRA to be the problem, the causal factor would have to be availability of credit in low-income communities. But from what I’ve read, it seems like today’s problem is no longer redlining — plenty of lenders were willing to lend to the poor. It’s predatory lending — they found that for various reasons it was easier to steer poor people into unnecessarily high-cost loans. Now, I’m no fan of policies to encourage homeownership in general. I think we have too many of them. But the CRA is primarily a policy to discourage discrimination, and that is something we unfortunately still need.

By James Kwak

Testimony submitted to the Congressional Oversight Panel, hearing on “The overall impact of the Troubled Asset Relief Program (TARP) on the health of the financial system and the general U.S. economy,” Thursday, November 19, 2009. (pdf version)

Submitted by Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; Senior Fellow, Peterson Institute for International Economics; and co-founder of http://BaselineScenario.com.

Summary

1)      In the immediate policy response to any major financial crisis – involving a generalized loss of confidence in major lending institutions – there are three main goals:

1. To stabilize the core banking system,
2. To prevent the overall level of spending from collapsing,
3. To lay the groundwork for a sustainable recovery.

2)      IMF programs are routinely designed with these criteria in mind and are evaluated on the basis of: the depth of the recession and speed of the recovery, relative to the initial shock; the side-effects of the macroeconomic policy response, including inflation; and whether the underlying problems that created the vulnerability to panic, are addressed over a 12-24 month horizon.

3)      This same analytical framework can be applied to the United States since the inception of the Troubled Asset Relief Program (TARP).  While there were unique features to the US experience (as is the case in all countries), the broad pattern of financial and economic collapse, followed by a struggle to recover, is quite familiar.

4)      The overall US policy response did well in terms of preventing spending from collapsing.  Monetary policy responded quickly and appropriately.  After some initial and unfortunate hesitation on the fiscal front, the stimulus of 2009 helped to keep domestic spending relatively buoyant, despite the contraction in credit and large increase in unemployment.  This was in the face of a massive global financial shock – arguably the largest the world has ever seen – and the consequences, in terms of persistently high unemployment, remain severe.  But it could have been much worse.

5)      There is no question that passing the TARP was the right thing to do.  In some countries, the government has the authority to provide fiscal resources directly to the banking system on a huge scale, but in the United States this requires congressional approval.  In other countries, foreign loans can be used to bridge any shortfall in domestic financing for the banking system, but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.

6)      Best practice, vis-à-vis saving the banking system in the face of a generalized panic involves three closely connected pieces:

1. Preventing banks from collapsing in an uncontrolled manner.  This often involves at least temporary blanket guarantees for bank liabilities, backed by credible fiscal resources.  The government’s balance sheet stands behind the financial system.  In the canonical emerging market crises of the 1990s – Korea, Indonesia, and Thailand – where the panic was centered on the private sector and its financing arrangements, this commitment of government resources was necessary (but not sufficient) to stop the panic and begin a recovery.
2. Taking over and implementing orderly resolution for banks that are insolvent.  In major system crises, this typically involves government interventions that include revoking banking licenses, firing top management, bringing in new teams to handle orderly unwinding, and – importantly – downsizing banks and other failing corporate entities that have become too big to manage.  In Korea, nearly half of the top 30 pre-crisis chaebol were broken up through various versions of an insolvency process (including Daewoo, one of the biggest groups).  In Indonesia, leading banks were stripped from the industrial groups that owned them and substantially restructured.  In Thailand, not only were more than 50 secondary banks (“Finance Houses”) closed, but around 1/3 of the leading banks were also put through a tough clean-up and downsizing process managed by the government.
3. Addressing immediately underlying weaknesses in corporate governance that created potential vulnerability to crisis.  In Korea, the central issue was the governance of nonfinancial chaebol and their relationship to the state-owned banks; in Indonesia, it was the functioning of family-owned groups, which owned banks directly; and in Thailand it was the close connections between firms, banks, and politicians.  Of the three, Korea made the most progress and was rewarded with the fastest economic recovery.

7)      If any country pursues (a) unlimited government financial support, while not implementing (b) orderly resolution for troubled large institutions, and refusing to take on (c) serious governance reform, it would be castigated by the United States and come under pressure from the IMF.  At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.  Serious countries do not do this.

8)      Seen in this context, TARP has been badly mismanaged.  In its initial implementation, the signals were mixed – particularly as the Bush administration sought to provide support to essentially insolvent banks without taking them over.  Standard FDIC-type procedures, which are best practice internationally, were applied to small- and medium-banks, but studiously avoided for large banks.  As a result, there was a great deal of confusion in financial markets about what exactly was the Bush/Paulson policy that lay behind various ad hoc deals.

9)      The Obama administration, after some initial hesitation, used “stress tests” to signal unconditional support for the largest financial institutions.  By determining officially that these firms did not lack capital – on a forward looking basis – the administration effectively communicated that it was pursuing a strategy of “regulatory forbearance” (much as the US did after the Latin American debt crisis of 1982).  The existence of TARP, in that context, made the approach credible – but the availability of unconditional loans from the Federal Reserve remains the bedrock of the strategy.

10)  The downside scenario in the stress tests was overly optimistic, with regard to credit losses in real estate (residential and commercial), credit cards, auto loans, and in terms of the assumed time path for unemployment.  As a result, our largest banks remain undercapitalized, given the likely trajectory of the US and global economy.  This is a serious impediment to a sustained rebound in the real economy – already reflected in continued tight credit for small- and medium-sized business.

11)  Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by government guarantees of various kinds, the head of financial stability at the Bank of England (Andrew Haldane) bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”

12)  Exacerbating this issue, TARP funds supported not only troubled banks, but also the executives who ran those institutions into the ground.  The banking system had to be saved, but specific banks could have wound down and leading bankers could and should have lost their jobs.  Keeping these people and their management systems in place serious trouble for the future.

13)  The implementation of TARP exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.”  This lowers their funding costs, enabling them to borrow more and to take more risk.

14)  The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard.  Very few outside observers – other than at the largest banks – find this convincing.

15)  In fact, TARP also allowed the US Treasury to make it clear that some individuals are “Too Connected to Fail”.  Financial executives with strong connections to the current and previous leadership of the New York Fed (e.g., through network connections of various kinds) have great power and enormous market value in this situation.

16)  The US recovery strategy hinges on continued low interest rates (and a continuation of quantitative easing).  This creates risks of a new global asset bubble, funded in dollars and driven by exuberance about prospects in emerging markets.  The Fed has already signaled clearly that it will not raise interest rates for a long while.

17)  Unless bank regulators limit the direct and indirect risk exposure of US financial institutions to this new supposedly low risk “carry trade”, we face the very real prospect of another, even larger crisis.

The remainder of this testimony provides supportive background material, in terms of the global macroeconomic context within which TARP has operated and some important details about the program’s implementation.

Global Macroeconomic Context

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

1. 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.
2. 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.
3. 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.

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.

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.

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.

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.

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.

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.

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.
• 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.

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.

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 and continued regulatory forbearance for banks.  This reasoning is flawed.

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.

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?

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.

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.

TARP Specifics

In a financial panic, the critical ingredients of the government response must be speed and overwhelming force. The root problem is uncertainty – in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude are insufficient to overcome this uncertainty. And the longer the response takes, the longer that uncertainty can sap away at the flow of credit, consumer confidence, and the real economy in general – ultimately making the problem much harder to solve.

Instead, however, the principal characteristics of the government’s response to the financial crisis have been denial, lack of transparency, and unwillingness to upset the financial sector.

First, there was the prominent place of policy by deal: when a major financial institution, got into trouble, the Treasury Department and the Federal Reserve would engineer a bailout over the weekend and announce that everything was fine on Monday. In March 2008, there was the sale of Bear Stearns to JPMorgan Chase, which looked to many like a gift to JPMorgan. The deal was brokered by the Federal Reserve Bank of New York – which includes Jamie Dimon, CEO of JPMorgan, on its board of directors. In September, there were the takeover of Fannie Mae and Freddie Mac, the sale of Merrill Lynch to Bank of America, the decision to let Lehman fail, the destructive bailout of AIG, the takeover and immediate sale of Washington Mutual to JPMorgan, and the bidding war between Citigroup and Wells Fargo over the failing Wachovia – all of which were brokered by the government. In October, there was the recapitalization of nine large banks on the same day behind closed doors in Washington. This was followed by additional bailouts for Citigroup, AIG, Bank of America, and Citigroup (again).

In each case, the Treasury Department and the Fed did not act according to any legislated or even announced principles, but simply worked out a deal and claimed that it was the best that could be done under the circumstances. This was late-night, back-room dealing, pure and simple.

What is more telling, though, is the extreme care the government has taken not to upset the interests of the financial institutions themselves, or even to question the basic outlines of the system that got us here.

In September 2008, Henry Paulson asked for $700 billion to buy toxic assets from banks, as well as unconditional authority and freedom from judicial review. Many economists and commentators suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands – indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.

After the “Paulson Plan” was passed on October 3, 2008, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit with a bank recapitalization program, unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt. Only then was enough financial force applied for the crisis in the credit markets to begin to ease, with LIBOR finally falling and Treasury yields rising, although they remained a long way from historical levels.

The money used to recapitalize (buy shares in) banks was provided on terms that were grossly favorable to the banks. For example, Warren Buffett put new capital into Goldman Sachs just weeks before the Treasury Department invested in nine major banks. Buffett got a higher interest rate on his investment and a much better deal on his options to buy Goldman shares in the future.

As the crisis deepened and financial institutions needed more assistance, the government got more and more creative in figuring out ways to provide subsidies that were too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was renegotiated to make it even more friendly to AIG. The second Citigroup and Bank of America bailouts included complex asset guarantees that essentially provided nontransparent insurance to those banks at well below-market rates. The third Citigroup bailout, in late February 2009, converted preferred stock to common stock at a conversion price that was significantly higher than the market price – a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that will be provided under the new Financial Stability Plan give the conversion option to the bank in question, not the government – basically giving the bank a valuable option for free.

Note that this strategy is not internally illogical: if you believe that asset prices will recover by themselves (or by providing sufficient liquidity), then it makes sense to continue propping up weak banks with injections of capital. However, our main concern is that it underestimates the magnitude of the problem and could lead to years of partial measures, none of which creates a healthy banking system.

The main components of the administration’s bank rescue plan included:

• Stress tests, conducted by regulators, to determine whether major banks can withstand a severe recession, followed by recapitalization (if necessary) in the form of convertible preferred shares
• The Public-Private Investment Program (PPIP) to stimulate purchases of toxic assets, thereby removing them from bank balance sheets

The administration as much as said that the major banks will all pass the stress tests, making it appear that the results were foreordained. Essentially, this was used to signal that the government stood behind the 19 banks in the stress test and would not allow any of them to fail.  Effectively, the government signaled which banks were Too Big To Fail.

We also do not expect the PPIP to meet its stated objective of starting a market for toxic assets (both whole loans and mortgage-backed securities) and thereby moving them off of bank balance sheets. In essence, the PPIP attempts to achieve this goal by subsidizing private sector buyers (via non-recourse loans or loan guarantees) to increase their bid prices for toxic assets. Besides the subsidy from the public to the private sector that this involves, we are skeptical that the plan as outlined will raise buyers’ bid prices high enough to induce banks to sell their assets. From the banks’ perspective, selling assets at prices below their current book values will force them to take writedowns, hurting profitability and reducing their capital cushion.

As long as the government’s strategy is to prevent banks from failing at all costs, banks have an incentive to sit the PPIP out (or even participate as buyers) and wait for a more generous plan. Again, the key question is how the loss currently built into banks’ toxic assets will be distributed between bank shareholders, bank creditors, and taxpayers. By leaving banks in their current form and relying on market-type incentives to encourage them to clean themselves up, the administration has given the banks an effective veto over financial sector policy. There is a chance that the PPIP will have its desired effect, but otherwise several months will pass and we will be right where we started.

Ultimately, the stalemate in the financial sector is the product of political constraints. On the one hand, the administration has consistently foresworn dictating a solution to the financial sector, either out of deep-rooted antipathy to nationalization, or out of fear of being accused of nationalization. On the other hand, bailout fatigue among the public and in Congress, aggravated by the clumsy handling of the AIG bonus scandal, has made it impossible for the administration to propose a solution that is too generous to banks, or that requires new money from Congress.

One problem with this velvet-glove strategy is that it was simply inadequate to change the behavior of a financial sector used to doing business on its own terms.

This continued solicitousness for the financial sector might be surprising coming from the Obama Administration, which has otherwise not been hesitant to take action. The $800 billion fiscal stimulus plan was watered down by the need to bring three Republican senators on board and ended up smaller than many hoped for, yet still counts as a major achievement under our political system. And in other ways, the new administration has pursued a progressive agenda, for example in signing the Lilly Ledbetter law making it easier for women to sue for discrimination in pay and moving to significantly increase the transparency of government in general (but not vis-à-vis its dealings with the financial sector).

And the Obama administration has pushed hard for a new agency to better regulate financial products offered to consumers.  This is a commendable effort that is likely to succeed, despite opposition from the financial sector.  Unfortunately, there has been no parallel effort to rein in the economic and political power of our largest financial institutions.

The power of the financial sector goes far beyond a single set of people, a single administration, or a single political party. It is based not on a few personal connections, but on an ideology according to which the interests of Big Finance and the interests of the American people are naturally aligned – an ideology that assumes the private sector is always best, simply because it is the private sector, and hence the government should never tell the private sector what to do, but should only ask nicely, and maybe provide some financial handouts to keep the private sector alive.

To those who live outside the Treasury-Wall Street corridor, this ideology is increasingly not only at odds with reality, but actually dangerous to the economy.

By Simon Johnson

This testimony draws on joint work with Peter Boone, particularly “The Next Financial Crisis: It’s Coming and We Just Made It Worse” (The New Republic, September 8, 2009), and James Kwak, particularly “The Quiet Coup” (The Atlantic, April, 2009).

This guest post was contributed by Raj Date, head of the Cambridge Winter Center for Financial Institutions Policy and a former McKinsey consultant, bank senior executive, and Wall Street managing director. For further information on the auto dealer exemption, see the recent study by the Cambridge Winter Center.

Over the past several months, Congress has debated ways to strengthen and rationalize consumer protection in financial services.  Central to that debate is the proposed creation of a new agency focused exclusively on this issue, the Consumer Financial Protection Agency (the “CFPA”).

Even among proponents, however, there are varying conceptions of the scope and function of the CFPA.  For example, the CFPA as envisioned by the House Financial Services Committee would exclude auto dealers from the CFPA’s coverage.  The Administration’s original proposal would have included them.  Starting this week, the Senate Banking Committee will have to wrestle with the same question.

They shouldn’t have to wrestle long:  Even by the low analytical standards applied to hastily arranged, crisis-driven corporate welfare initiatives, the exemption of auto dealers from the CFPA appears profoundly ill conceived.  Exempting auto dealers would simultaneously be bad for consumers, bad for industry stability, and bad for what remaining sense of free-market integrity we still have.

First, and most obviously, exempting auto dealers from the CFPA would be a big step in exactly the wrong direction on consumer protection.

One the central premises of the CFPA is that it would provide comprehensive rule-making — that is, regardless of what a firm chooses to call itself (bank, thrift, finance company, ILC, investment bank, broker — whatever), if it sells financial products, then it should be subject to the same rules of the road as every other competitor.  Absent the same rules applying to all players, the marketplace becomes a “race to the bottom”:  all participants migrate to the most permissive system of rules, and customer practices degrade to the lowest common denominator.  (And then one day you wake up, and everyone is marketing teaser-rate option-ARMs).

So by that logic, if auto dealers are selling loans, then they should be subject to the same rules as everyone else.

And auto dealers are certainly selling loans.

Dealers are not a niche part of some obscure and immaterial market; they are the single largest channel (with 79% market share) in the origination of auto loans and leases, a business that (at more than $850 billion in outstandings) is larger than the entire U.S. credit card industry.

Not only are dealers a giant part of auto lending, but auto lending is a giant part of dealer economics.  Over the past ten years, gross profit per new car has plummeted by a third.  That would seem catastrophic in what was, even a decade ago, the brutally thin-margin business of selling cars.  But dealers, somehow, still were profitable in 2008.  The main reason:  Over this same period, dealers were able to double their amount of higher-margin finance and insurance income.

Moreover, auto finance is demonstrably susceptible to unfair and deceptive practices, and those practices are demonstrably not held in check by private market forces alone.  Just like mortgage brokers during the bubble, auto dealers have the opportunity to mark up interest rates; they routinely and confusingly cross-subsidize finance pricing and vehicle pricing; they can and do add “garbage” fees and add-ons of questionable provenance and dubious value.  (Can I interest you in undercarriage coating?  How about paint protection?).

So auto dealers are in the business of selling loans — a lot of loans — and their business model is susceptible to abuse.  This is not a close call; they should be subject to the same rules as other players.

But this problem goes beyond consumer protection; it goes to the stability of the system.

The auto finance market consists of two basic distribution channels:  the dealer (or “indirect”) channel, which is generally funded by a handful of large national banks and Wall Street capital markets platforms; and the retail (or “direct”) channel, which generally consists of credit unions and community banks.  By artificially distorting the auto finance market in favor of the dealers’ distribution channel, the exemption encourages the primacy of Wall Street funding sources over traditional bank deposit funding.  As evidenced by the crisis, intentionally chasing businesses from traditional banks and credit unions into Wall Street funding models creates the real potential for disruptive volatility over time.

Finally, the exemption also offends even the most basic principles of regulatory fairness.  Free-market adherents should be dismayed by the notion of specially permissive regulatory treatment for some classes of politically powerful market participants.  We should not be stacking the deck in favor of the already-dominant players with the most dubious customer practices (auto dealers and the captive finance companies and Wall Street houses that fund them), and thereby discriminating against competitors with more transparent, customer-friendly business models (community banks and credit unions chief among them).

By Raj Date

This morning, starting at 9:30am, the Congressional Oversight Panel holds a hearing to assess the performance of the Troubled Asset Relief Program (TARP).  The hearing will be streamed live and also archived, featuring testimony from: Dean Baker (Center for Economic and Policy Research), Charles Calomiris (Columbia University), Alex Pollock (American Enterprise Institute), Mark Zandi (Moody’s Economy.com), and me.

In late September 2008, Secretary of the Treasury Henry S. Paulson asked Congress for $700 billion to buy toxic assets from banks, as well as unconditional authority and freedom from judicial review. Many economists and commentators suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands – indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that approach was shelved.

In any case, after the TARP was passed on October 3, 2008, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit by using TARP to fund injections of capital into banks, as well as unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt.

The overall US policy response to the crisis did well in terms of preventing spending from collapsing.  Monetary policy responded quickly and appropriately.  After some initial and unfortunate hesitation on the fiscal front, the stimulus of 2009 helped to keep total domestic spending relatively buoyant, despite the contraction in credit and large increase in unemployment.  This was in the face of a massive global financial shock – arguably the largest the world has ever seen – and the consequences, in terms of persistently high unemployment, remain severe.  But it could have been much worse.

There is no question that passing the TARP was an essential element in restoring confidence.  In some countries, the government has the authority to provide fiscal resources directly to the banking system on a huge scale, but in the United States this requires congressional approval.  In other countries, foreign loans can be used to bridge any shortfall in domestic financing for the banking system, but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.

But if any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF.

At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.  Serious countries do not do this.

Seen in this context, TARP has been badly mismanaged.  In its initial implementation, the signals were mixed – particularly as the Bush administration sought to provide support to essentially insolvent banks without taking them over.  Standard FDIC-type procedures for failed institutions, which are best practice internationally, were applied to small- and medium-banks, but studiously avoided for large banks.  As a result, there was a great deal of confusion in financial markets about what exactly was the Bush/Paulson policy that lay behind various ad hoc deals.

The Obama administration, after some initial hesitation, used “stress tests” to signal unconditional support for the largest financial institutions.  By determining officially that these firms did not lack capital – on a forward looking basis – the administration effectively communicated that it was pursuing a strategy of “regulatory forbearance” (much as the US did after the Latin American debt crisis of 1982).  The existence of TARP, in that context, made the approach credible – but the availability of unconditional loans from the Federal Reserve remains the bedrock of the strategy.

The downside scenario in the stress tests was overly optimistic, with regard to credit losses in real estate (residential and commercial), credit cards, auto loans, and in terms of the assumed time path for unemployment.  As a result, our largest banks remain undercapitalized, given the likely trajectory of the US and global economy.  This is a serious impediment to a sustained rebound in the real economy – already reflected in continued tight credit for small- and medium-sized business.

Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”

The implementation of TARP exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.”  This lowers their funding costs, enabling them to borrow more and to take more risk.  The consequences appear in your tax bill and your job prospects.

By Simon Johnson

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

One of our readers pointed me to a paper by Edward Kane with the unfortunately complicated title “Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and Contracting a Financial Institution’s Accounting Balance Sheet.” The paper is an extended discussion of regulatory arbitrage — not the specific techniques (such as securitization with various kinds of recourse) that banks use to finesse capital requirements, but the larger game played by banks and their regulators. This is how Kane frames the situation:

“Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time.  In this game, regulatees tend to make more moves than regulators do.  Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.

“Thirty years ago, regulatory arbitrage focused on circumventing restrictions on deposit interest rates; bank locations; charter powers; and deposit institutions’ ability to shift risk onto the safety net.  Probably because regulatory burdens in the first three areas have largely disappeared, the fourth has become more important than ever.  Today, loophole mining by financial organizations of all types focuses on using financial-engineering techniques to exploit defects in government and counterparty supervision.”

Large banks can increase the benefit to them of the government safety net by becoming larger, more complicated (less transparent to regulators), and more politically powerful; yet, as Kane observes, they do not exhibit increasing returns to scale. The implication? “As institutions approach and attain TDFU [too difficult to fail and unwind] or TBDA [too big to adequately discipline] status, value maximization leads them to trade off diseconomies from becoming inefficiently large or complex against the safety net benefits that increments in scale or scope can offer them.” In other words, mega-banks take on the inefficiencies of being complicated, unwieldy, bureaucratic, etc. because they are compensated for by greater safety-net benefits.

In this interpretation, the point of structured finance is not just to reduce capital requirements, but to make it harder for regulators to estimate systemic risk implications and easier for them to ignore what is going on. Unfortunately, regulators do not face incentives that motivate them to take appropriate corrective action. Instead, “history shows that top supervisory officials that respond in a market-mimicking way [that is, the way private creditors would respond] to these signals [of financial deterioration] at TDFU firms must expect to be pilloried rather than praised both in congressional hearings and in the press.” Instead, Kane proposes that heads of regulatory agencies be paid in part through deferred compensation that would potentially be forfeited based on the performance of the institutions they supervised during the subsequent years, including the years after they left office.

One conclusion we can draw is that the bigger and more complex a bank, the harder it will be for regulators to adequately monitor what is going on, and this is one reason that banks make themselves big and complex (it doesn’t just happen by itself). This seems important to bear in mind in assessing the likelihood that current regulatory reform proposals will do the job they are supposed to do.

By James Kwak

This guest post was submitted by Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics.  Arvind is a leading proponent of the view that we need to rethink capital controls - he sees them as central to meaningful macroprudential regulation going forward.  (He also has an op ed in today’s Financial Times, on climate change, economic development, and the basis for an international agreement.)

The Bretton Woods Committee is organizing a panel (today, Wednesday) on the role of the G-20 in coordinating global growth with speakers from the IMF, US Treasury, and the G-24 group of developing countries.  “Global imbalances” (the US current account deficit, the Chinese current account surplus, etc) will be discussed extensively. But I will also raise the question of whether there is a new imbalance in the world economy that threatens emerging markets, and what they should do about it.

Extraordinarily loose monetary policy and the resulting close-to-zero interest rates in many industrial countries are pushing capital out to emerging markets—Brazil, China, and India—whose growth prospects are buoyant and relatively unaffected by the crisis. Brazil’s currency has appreciated by 30 percent this year, India’s stock market soared by 70 percent, and China is once again furiously accumulating foreign exchange reserves, $62 billion in September.

Now, foreign capital can be good for emerging markets because it brings down the cost of capital for domestic firms, provides finance, facilitates greater investment, and boosts growth. But, as my co-authors and I have shown in two papers, the evidence in favor of foreign capital is awfully hard to find.

In part, this is because foreign capital causes the exchange rate to appreciate which hurts exports, especially in manufacturing, and growth in the long run. Another reason is that domestic financial systems and their regulation are not strong enough to prevent and cope with financial crises that result when foreign capital bolts for the exits.  Time and again we have learnt (or rather failed to learn) that large foreign capital flows to emerging markets are not sustainable (Latin America 1982; Asia 1997-98; and Eastern Europe 2008). Think of this: if sophisticated regulatory systems such as those in the US and Europe cannot avoid financial crises, how much more vulnerable are emerging markets?

So, how should emerging market countries respond? Is it time for them to impose serious restrictions on capital flows?  In answering these questions, two points must be kept in mind: this policy challenge is going to be around for some time, at least as long as the Fed keeps interest rates low; and second, because the cause of the increased flows is common to all countries, namely Fed policy, it will be a policy challenge not just for individual countries but for  emerging markets as a group.

Chile in the early 1990s and Malaysia in the wake of the Asian financial crisis in the late 1990s are the two poster boys for serious capital account restrictions. The evidence on their effects—in limiting flows and preventing currency overvaluation—is contested because restrictions can be circumvented. But Carmen Reinhart and Nicholas Magud suggest that their effects cannot be dismissed.

Going forward, there is the technical question of how best to design restrictions on flows: Should they be price-based or quantity-based? What kinds of flows are best addressed, debt or portfolio? When should they be withdrawn? The IMF should deploy its considerable technical expertise to help answer these questions.

But there is also the political issue of removing the stigma from countries that want to impose serious capital controls. Brazil recently botched its attempt at such controls because the policy action was half-hearted, anxious about the reaction of markets. One possibility could be coordinated restrictions on capital flows action by a set of emerging markets that could be blessed by the G-20.  No doubt this would be risky, perhaps even counter-productive, but in these unusual times no policy option should be off limits, at least for discussion.

By Arvind Subramanian

“Banking on the State” by Andrew Haldane and Piergiorgio Alessandri is making waves in official circles.  Haldane, Executive Director for Financial Stability at the Bank of England, is widely regarded as both a technical expert and as someone who can communicate his points effectively to policymakers.  He is obviously closely in line – although not in complete agreement - with the thinking of Mervyn King, governor of the Bank of England.

Haldane and Alessandri offer a tough, perhaps bleak assessment.  Our boom-bust-bailout cycle is, in their view, a “doom loop”.  Banks have an incentive to take excessive risk and every time they and their creditors are bailed out, we create the conditions for the next crisis.

Any banker who denies this is the case lacks self-awareness or any sense of history, or perhaps just wants to do it again.

The Haldane-Alessandri “doom loop” is fast becoming the new baseline view, i.e., if you want to explain what happened or – more interestingly – what can happen going forward, you need to position your arguments relative to the structure and data in their paper. 

For example, at Mr. Bernanke’s reconfirmation hearing, these issues will come up in some fashion.  The contrast between the hard-hitting language of the “doom loop” and Ben Bernanke’s odd statements on the dollar yesterday could not be more striking.  Still, there is no reason to regard the Haldane-Alessandri version of the doom loop as the final word; in fact, this where the debate now heads.  (This link gives as useful introduction to relevant aspects of banking theory, as well as Eric Maskin’s insightful personal take.)

To help move the discussion forward, here are some issues for Banking on the State raised in discussions with top experts (who prefer to remain anonymous):

1. The authors say that it is clear, in retrospect, that banks were excessively leveraged.  But how did regulators/supervisors miss the implications of this at the time?  Banks’ balance sheets started expanding from 1970 onwards (page 3) and by 2000 “balance sheets were more than five times annual UK GDP.”  This was not an overnight development – see the last sentence on page 8 which says “Higher leverage fully accounts for the rise in UK banks’ return on equity up until 2007″.  It may be difficult for a central banker to come clean on who convinced whom that modern banking in this form is safe - but at a minimum the authors should draw lessons from earlier failures of regulators/supervisors when discussing prospective changes in the framework of regulation. Could some of the changes being proposed suffer the same fate as all previous attempts to regulate big banks? It seems the authors answer is that just moving things to Pillar I (from Pillar II) will help.  This sounds like wishful thinking.
2. The author are right that US banks faced a leverage ratio constraint, which European banks did not.  But US banks circumvented this by setting up SIVs – see the damage at Citi for details.  Again, what were the regulators/supervisors thinking when they allowed this?
3. The authors assume that the equity owners of banks are almost always protected and therefore “the rational response by market participants is to double their bets”. This does not seem to have been true in practice.  For example, why was it so difficult for banks to raise capital after the initial flurry of new capital from Sovereign Wealth Funds (SWFs)? Why did some banks share prices fall so much (Citi, Merrill Lynch, Morgan Stanley, etc)? This cannot not be characterized as a rational response by markets if equity holders were implicitly protected. In fact, new capital (either from the state, or even in some cases from SWFs) came in the form of (expensive) preferred stock and diluted existing holders.  The doom loop is surely more about what happens to insiders (rich and powerful bank executives, with strong political connections) and creditors (investment funds run by rich and powerful nonbank executives, with strong political connections).
4. Part of the (relatively) reasonable performance of hedge funds was due to them being forced quite early on to reduce leverage and asset holdings because banks were short of capital and tightened lending conditions. This fortuitously allowed hedge funds to reduce exposure before the crisis became most acute.  Haldane and Alessandri seem a little too inclined to believe the hedge funds’ own rhetoric at this stage.  This is worrying – the intellectual origins of our last crisis lie with central bankers believing that the private financial sector has evolved into a safer form. 
5. To be clear, and a little contrary to what the authors imply: Most hedge funds do not operate with unlimited liability.  Often they have “watermark” provisions, limiting their fees while the fund shows losses.  But it is a simple matter to close down a failing fund and, a week or so later, open another (how many funds has John Meriwether closed?).  This will feed the next doom loop.
6. The private sector is unlikely to be able to self insure (e.g., various proposals discussed on page 18) because of the potential size of losses in a systemic event. We know there was private insurance for a large portion of the assets (CDOs insured through monolines, for example) but these insurers did not have credible resources. Similarly, implicit state guarantees may also not be sufficient (e.g., Iceland). This suggests strict controls on size of the financial system relative to the economy (and the tax base) may be necessary.
7. The paper is also relatively weak on the role of monetary policy in fuelling the doom loop.  But that is relatively easy to add on.

The overall conclusion of the paper follows uneasily from the main analytical thrust.  How can we believe that for the regulators, “next time is different“?  Most likely, next time will be exactly the same, with different terminology: the financial sector “innovates”, regulators buy their story that risks are now properly managed, and the ensuing bailout (again) breaks all records.

It’s all politics.  Unless and until you break the political power of our largest banks, broadly construed, we are going nowhere (or, rather, we are looping around the same doom). 

Barney Frank points out that small banks have political clout also, and of course he’s correct that this drives some issues.  But how many small banks spend their time (and lobbying dollars) on Capitol Hill insisting that large banks must not be broken up?

Our core problem is that we now have banks that are Too Big To Fail; if you don’t agree, read and publicly refute Haldane.  In theory, these big banks could be effectively regulated, but this is a leap of faith that experienced policymakers (e.g., Mervyn King and Paul Volcker) are increasingly unwilling to make. 

The biggest banks must be broken up.  This is not sufficient to end the doom loop, but it is necessary.

By Simon Johnson

I would like to strongly recommend Steve Randy Waldman’s recent post on “Discretion and Financial Regulation.” He begins like this: “An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.” It gets better from there.

In fact, I’d recommend it over anything I’ve written this morning, so why don’t you head over now.

By James Kwak

Gretchen Morgenson of The New York Times (hat tip Calculated Risk) reports that the recent Worker, Homeownership and Business Assistance Act of 2009 (which included the expansion of the homebuyer tax credit) included a curious tax break for money-losing companies:

“a tax break that lets big companies offset losses incurred in 2008 and 2009 against profits booked as far back as 2004. The tax cuts will generate corporate refunds or relief worth about $33 billion, according to an administration estimate.

“Before the bill became law, the so-called look-back on losses was limited to small businesses and could be used to counterbalance just two years of profits. Now the profit offset goes back five years, and the law allows big companies to take advantage of it, too.”

Morgenson focuses on the fact that some of the biggest beneficiaries will be the massive home-building companies that raked in huge profits during the height of the boom, and that they have no apparent plans to hire new workers. “After spending its $210,000, Pulte will receive $450 million in refunds. And Hovnanian, after spending its $222,000, will get as much as $275 million.” (If you’re not enraged by the behavior of some of these companies, you should read Chapter Five of Our Lot by Alyssa Katz.)

But leaving aside the link to home builders, here’s the puzzler: what’s the plausible economic justification for this tax break?

We generally allow tax loss carry-forwards, which means that if a company loses money in one year it can count that loss against the profit it makes the next year. I can think of a few plausible justifications for this policy. The first is that tax years are arbitrary and it’s more fair to tax profits without regard to specific timing. The second is that without such a policy, companies would have even more motivation to cook their books to smooth our their profits over time than they already do. The third is that this helps startup companies that tend to lose money early in their lives, and we want to help startups.

What about tax loss carry-backs, where you get to match losses this year against profits in previous years and claim a cash refund? I guess the fairness consideration still applies. The second doesn’t, or it’s much weaker, because the right incentive is already in place because of the carry-forward policy. The third doesn’t apply. Actually, the opposite applies. Either the company will turn a profit in the future, in which case it will be allowed to take advantage of the carry-forward. Or it will never turn a profit in the future, in which case this is a huge benefit — but why do we want to be helping companies that will never turn a profit again?

Finally, though, what happens when you switch from a regime without carry-backs to a regime with carry-backs? In this case, you end up writing $33 billion of checks to a group of companies that are selected solely on the basis that they are losing money now but made money in the past five years. Of all of the ways that the government could spend money to (a) stimulate the economy or (b) help people, how did this one make the cut?

By James Kwak

A reader pointed out a quick analysis done by Dean Baker and Travis McArthur of the Center for Economic Policy and Research back in September. They estimate the value of being “too big to fail” by looking at the spread between the cost of funds for banks above $100 billion in assets and banks below that level. The spread averaged 0.29 percentage points from 2000 through 2007, but rose to 0.78 percentage points from Q4 2008 through Q2 2009, an increase of 0.49 percentage points. Alternatively, the spread peaked at 0.69 percentage points from Q4 2001 through Q2 2002 at the end of the last recession; by comparison, the spread this time around was only 0.09 percentage points higher. Using 0.09 and 0.49 percentage points as their low and high estimates, Baker and McArthur come up with an estimate of the aggregate value of being TBTF that ranges from $6.3 billion to $34.2 billion per year.

That’s a huge range, and Baker and McArthur say we’ll need to see if the spread comes in over time to see if this represents a true long-term change in the importance of being big.

They also estimate that 9-48% of the big banks’ recent profits are due to the TBTF subsidy. Of course, to that must be added the excess profits that companies can gain simply by being big due to pricing power in oligopolistic markets.

Logically speaking large banks could plausibly provide benefits that outweigh these costs. I just haven’t seen many attempts at quantification of such benefits.

By James Kwak

This guest post was submitted by Joe Gagnon, a senior fellow at the Peterson Institute for International Economics.  Joe is an expert on international economics has spent a great deal of time studying the effects of exchange rate depreciation.  Even if the dollar depreciates sharply in the near term, he argues that is unlikely to have adverse effects – primarily because inflation will stay low.

Pundits and policymakers around the world are wringing their hands over the possibility of further declines in the foreign exchange value of the dollar.  Predicting exchange rates is notoriously difficult; there is almost as much chance of the dollar rising next year as of it declining.  But if the dollar were to fall further, should we be concerned?

A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers.  However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies.  Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.

The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries.  The correct response is to ease monetary policy and temporarily delay fiscal contraction.  As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls. 

For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery.  The fear is that a falling dollar would be inflationary.  However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level.  With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term.  Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar).  Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it.  Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.

For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma:  how fast to tighten macroeconomic policy as the economy recovers?  These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation.  These differences will determine the appropriate policy stance.  To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs.  In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.   

By Joseph E. Gagnon

Note: I’ve updated this post at the end with another response to Jamie Dimon, this one by James Coffman. Coffman served in the enforcement division of the SEC for over twenty years, most recently as an assistant director of enforcement, and previously wrote a guest post for this blog.

In the Washington Post, Jamie Dimon asserts that we shouldn’t “try to impose artificial limits on the size of U.S. financial institutions.” Why not?

“Scale can create value for shareholders; for consumers, who are beneficiaries of better products, delivered more quickly and at less cost; for the businesses that are our customers; and for the economy as a whole.”

I don’t know of any serious person who believes this to be true for banks above, say, $100 billion in assets. Charles Calomiris, who studies this stuff, couldn’t find anything stronger to back up the economies of scale claim than a study saying that bank total factor productivity grew by 0.4% per year between 1991 and 1997 — a study whose author thinks that the main factor behind increasing productivity was IT investments.

“Artificially limiting the size of an institution, regardless of the business implications, does not make sense.”

Uh … obviously it makes sense. We all know that having banks that are TBTF is bad. One solution is making them smaller. Big banks may (theoretically) have benefits that outweigh the benefits of shrinking them. But shrinking them makes perfect sense unless those benefits are proven.

“To understand the harm of artificially capping the size of financial institutions, consider that some of America’s largest companies, which employ millions of Americans, operate around the world. These global enterprises need financial-services partners in China, India, Brazil, South Africa and Russia: partners that can efficiently execute diverse and large-scale transactions; that offer the full range of products and services from loan underwriting and risk management to providing local lines of credit; that can process terabytes of financial data; that can provide financing in the billions.”

Does Jamie Dimon really believe this? Doesn’t he run a bank when he isn’t writing op-ed articles? The last time Johnson & Johnson issued debt, it used eleven underwriters. The time before that, it used thirteen. (I only chose J&J because it was the example picked by Scott Talbott, a financial industry lobbyist.) Now, do J&J’s dozens of subsidiaries around the world all get local lines of credit from the same bank? Does J&J really want to be dependent on a single source of credit? (Actually, if that single source has a government guarantee, it could do worse.) If that’s actually true, someone please let me know. But the idea that one of the world’s largest companies would need a one-stop shop for financial services is what defies basic business sense.

Now, I’m willing to concede that there is value to having a global investment bank; at the least, you want trading operations covering all the time zones. And I’m willing to concede that there is some minimum scale to having a sophisticated trading and derivatives operation. But I go back to the number $270 billion. That’s how big Goldman was in 1998, adjusted to today’s dollars. I still haven’t heard a good argument about why the nonfinancial world has changed in a way that requires investment banks that are larger than $270 billion. I also haven’t heard a good argument why a $270 billion investment bank needs to be attached to a $1.5 trillion domestic retail bank (think of Bank of America).

“Capping the size of American banks won’t eliminate the needs of big businesses; it will force them to turn to foreign banks that won’t face the same restrictions.”

On one level, so what? If big American companies want to do business with UBS — a bank that gets bailed out by Swiss taxpayers when necessary — that’s fine with me, and fine with those companies as well. More seriously, of course, that means that Switzerland should also break up its big banks.

“Global economic growth requires the services of big financial firms.”

Just because you keep saying the same thing over and over again doesn’t make it true.

By James Kwak

Update: And here’s the response by James Coffman.

To the editor:

Jamie Dimon’s opinion piece, “No more ‘too big to fail’,” bases its argument on a false dichotomy and glosses over, at best, the very real problem of interconnectedness.

First, the choice facing lawmakers is not an either/or choice between a resolution authority to wind down failing financial institutions and the imposition of artificial and arbitrary limits on the size of such institutions.  While the establishment of a resolution authority is probably necessary, it is not a substitute for restructuring the financial system to prevent TBTF institutions in the future and to remove the threat they pose today.  The best, most effective and only proven method for doing this is to separate commercial banking, which is supported by the government’s guarantee in the form of deposit insurance, from the investment banking function, which involves much greater risk resulting from trading, securitization, development and sale of exotic financial products, etc.  If those functions are separated, as they were for nearly sixty years until the 1990’s, the market will help control size and risk.

To enhance the ability of market forces to affect size and risk, it is important that investment banks in the future be owned in large part by their employees.  If the bankers have their own net worth at stake, they will control the risk the institution assumes.  Self-interest is a strong disciplinarian. Investment banks should not be publicly owned.  Many of the recent reckless practices can be traced back to the demise of investment banking partnerships. Instead of public shareholders, let them rely on the credit markets and their own equity to finance their activities.

In order for the credit markets to act as a restraining force, all financial institutions should be required to make detailed, uniform and understandable disclosure of their financial activities and balance sheets. Only when such information is available can markets measure risk before lending or investing.  The market can discipline risk only when it can measure it.

Finally, Mr. Dimon’s statement that the problem of interconnectedness of finiancial institutions is best handled by a resolution authority would be funny if it weren’t so dangerous and disingenuous.  How can a resolution authority cure the interconnectedness problems of a failed institution that has billions of dollars of unhedged and unbacked credit default swaps or other derivatives outstanding?  Interconnectedness problems must be identified and addressed before an institution fails.  They can best be identified and measured if the underlying transactions that give rise to interconnectedness are known and understood by markets and regulators before the institution fails.  The best means for accomplishing this is by establishing transparent clearing mechanisms and disclosure regimes.  The banking industry is currently spending millions of dollars on lobbyists in an attempt to weaken such measures.

Our lawmakers need to resolve to never again allow financial institutions to become too big to fail.  With the proper market structures in place, the markets can do that more effectively than micro-regulation.  If the markets fail at this task, as they have in the past, regulators will have enough accurate and timely information to resolve such problems without huge slugs of taxpayer money and before such problems pose a threat to the world economy.

Gillian Tett has an article criticizing the idea that CoCos — contingent convertible bonds — will solve the “too big to fail” problem. (And yes, she calls it “too big to fail,” even though Gillian Tett of all people understands what interconnectedness means.)

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

Tett is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.

I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.

So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:

“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”

Tett says what we need is a cross-border resolution system for bank failures. I’m a little skeptical of that too, for reasons I think I’ve outlined elsewhere. In case I haven’t, this is the problem: When push comes to shove, would the U.S. government use whatever “resolution” powers it has to take over JPMorgan Chase or Goldman Sachs against its will (or let an international body do so)? Leaving aside the issue of political connections for the moment, the political hit it would take from the right (SOCIALISM!!!) would make the health care debate look like a friendly game of flag football. If we can’t even get meaningful derivatives regulation in 2009, what makes us think that any government would have the political capital to take over one of America’s biggest banks when it needed to? More technocratic hubris.

But I agree strongly with Tett on why contingent capital is suddenly so popular. Policymakers in Washington are looking for something, anything that will allow them to declare victory over the TBTF problem — without having to break up the banks. The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:

1. Break up any institution that is too big to fail.
2. Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.

That’s the real choice.

By James Kwak