Over on the Economist Roundtable, my colleague Daron Acemoglu makes several important points.
- We now have some financial institutions (and perhaps nonfinancial firms also) that have such strong and deep political connections, they will not be allowed to go bankrupt. This is a reality we must face.
- Assuming that we can address such a deep political problem with a tweak of our regulatory arrangements is a dangerous illusion.
- And it is less than convincing to assert that central bank “independence” offers either a model for regulators or even something that works well at present on its own terms.
The same roundtable also features separate comments by Raghu Rajan, Charles Goodhart, and me.
By Simon Johnson
The Baseline Scenario 
When 85% of derivatives exposure (notional amounts of which total some $205Tln) is concentrated in 5 big banks they are connected indeed (as I argue on my blog, link below).
More to your point, and a sure sign of an economy in Minsky’s Ponzi Finance stage, the state has accepted the premise of too big (or too important or too connected, take your pick) to fail. Another sign of the Ponzi finance stage is the state’s love affair with finance, and disdain for the users of capital as amply demonstrated when the banks were bailed out but real sector corporations sent packing.
Alas for the 5 big banks, I believe they have become too big to bail (out). I used to trade derivatives at Chase and the costs incurred from winding down a derivatives book are often far greater than suggested by VaR analysis- sometimes a hedge isn’t a hedge. Bankers Trust and Warren Buffett’s experience with General Re speak to this issue.
The key question, to my mind, is not Fed independence but Fed political will. Aside from Paul Volcker, what Fed Chairman has been truly willing to squeeze the excess from the system? An independent Fed allowed the current excess to manifest.
Alan Blinder, a Princeton Professor who has argued for Federal Reserve transparency many times has recently written an excellent paper discussing the way the Fed communicates with the public.
I think the fact that Paul Volcker’s opinions and voice have been muted at the White House is quite bothersome. I think it might show that President Obama (although a great leader generally, who I support) is not grasping this particular problem very well. Also Joseph Stiglitz doesn’t seem to have much sway at the White House anymore. We have these 2 great minds that have basically been told by the White House “We got this one covered, thanks but no thanks”.
Here is the Alan Blinder paper. It also includes some remarks by his peers. The paper itself (not counting references) is 15 pages long. But Professor Blinder makes the topic much more interesting than you might imagine.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1440233
Dave Lewis: “the costs incurred from winding down a derivatives book are often far greater than suggested by VaR analysis- sometimes a hedge isn’t a hedge.”
It’s a thicket.
;)
I want to add, I don’t think AFTER Paul Volcker left the Federal Reserve, that the Federal Reserve was TRULY independent. You had Greenspan meeting with Bush for breakfast, and the two men had a virtual love feast together so that Greenspan would put a smiley face sticker on Bush’s tax cuts. That doesn’t spell out “independence” to me.
Greider’s Secrets of the Temple doesn’t paint a picture ot Fed independence before Volcker either. Arthur Burns is described as something of a sycophant.
It’s depressing…
That is the major reason for some sort of statutory “burning the ships;” there needs to be some significant constraint to the endless bailout cycle, and there needs to be some credible way of communicating the policy change.
This is just an American USD denominated problem, right? What’s the panic? Just find an investment vehicle without this USSR style collusion before the next big bank unleashed recession.
Dave: If the bank in question was using the level of cost accounting that was commonplace in industry 50 years ago, in place of say “far greater than the suggested by VaR analysis,” the bank could know precisely what that cost is.The VaR guess would be all the wiser for it.
The difficulty, in my experience, in calculating a definitive value is that the relationship of derivative securities’ value to the underlying, except at termination, is tenuous at times. When markets are liquid, these securities tend to trade near modeled values (with caveats) but when markets are illiquid there is often no price.
Further problems arise when the cash flows of the derivatives rise far above those associated with the underlying instrument. Take credit default swaps. In the event of a default, the underlying cash flows are limited to the cash on hand and whatever assets are tied to the security. One can theoretically bet in the CDS market on many multiples of that figure.
Most succinct and most accurate, Simon! And the formula you site is not limited to “too-big-to-fail” financial institutions. It includes concomitants in the arms, drug and Middle East policy areas as well.
Our democracy has been stolen from us and it was inside job. The usually proffered remedies are the very definition of naivete. This problem will prove intractable until it is faced with massive public demonstrations and economy stopping strikes. The solutions have long surpassed the purely economic.
Et al:
A little irony here. Although people may be familiar with the “Friend of mine/Friend of ours” dichotomy via The Sopranos, the term used by many outsiders to describe anyone who has an associate in the Mafia, or some tangential relation thereto is “CONNECTED.” This is NY Metro Area patois. Can’t speak for the rest of the country.
I have a question: How does point number 1 not show that our government is pretty much done? I mean, if that’s really reality… if there’s really businesses that will simply not be allowed to fail by slipping money in the right pockets, why are we not ousting those responsible right now? Why are we talking and not wielding pitchforks and torches?
Point 3 is especially interesting given its sacred cow properties. I wonder what Simon’s views are on using elections rather than appointments to select regulators. There is some public choice literature on the issue (Besley and Coate 2000) as well as practical experimentation in some US states -commissioners in the insurance, gas and electricity industries are elected.
Evidence suggests that elections help unbundle issues, making reguation more salient for voters rather than something gets pushed aside and hammered out behind closed doors by technocrats and interest groups – the “playbook” approach that was so expertly picked apart in another entry.
Certainly, the evidence suggests that elections make regulatory outcomes more pro-consumer, resulting in lower costs; though this can undercut firms decision to invest which is premised on earning an acceptable rate of return (states with electricity regulators appear to suffer more frequent power interruptions). I wonder how this trade-off would play out in financial markets?
Of course, in distributional terms, electing regulators will be welfare-enhancing to the extent that we think rents should be transferred from producers/shareholders to consumers/taxpayers.
We now have large banks, car companies and soon health care insurers whose business models are so unsustainable that they cannot survive without massive taxpayer (worker) subsidies.
And just to make sure the peons keep slaving away, we’ll saddle them down with enough debt to make sure it’ll take them six generations to pay it off.
Brilliant!
The most poignant feature of this whole TBTF episode is seeing well-intentioned, responsible, intelligent citizens reveal their amazement that the U.S. government is a wholly-owned subsidiary of the wealthiest corporations. Is greed and incestuous relations with rich speculators something new in our politicians? You might begin your historical perspective by reading “Washington’s Expense Account” (referring to the first George W).
Yeah, let’s directly elect our regulators. Then we can have really competent, ungreedy, uncorrupt people like Richard Nixon, Bill Clinton, and George W. Bush.
Nathan, one theme on this blog it that politicians have been captured by lobbyists and the oligarchy. So electing regulators might compound the problem. There could be problems with special interest groups “buying” regulators through campaign financing.
Bravo, Simon!!! I nominate you as the new chair of the Fed, and Elizabeth Warren to head up a new Federal Office of Financial Regulation.
This is a surprising discovery.
John Galbraith has been saying just that about all the major crashes. How do you want to control anything when, from bottom to top, everybody thinks the same? This time it may even have been worse that what Galbraith had in mind: the US government reformed the financial system to make it riskier and the FED was the chief arsonist.
I think that if there were a workable bankrupcy option for non-bank financials then the political costs of bailouts would be much, much higher and, therefore, much less likely.
http://www.pewfr.org/task_force_reports_detail?id=0016
The Fed was used as the chief arsonist. Who used it?
Please don’t fall in love with every pretty one that they put in front of you.
WE NEED A VETTING PROCESS