Our Eurozone Call In October 2008 And Banking Reform Today

By Simon Johnson

Eighteen months ago, on October 24, 2008, Peter Boone, James Kwak and I published an opinion piece in the Guardian (UK), “Start by Saving the Eurozone“.  We argued that the recession would put a great deal of pressure on the eurozone, because of flaws in its design.

Our proposals for addressing these issues, and preventing a broader global crisis, included:

“2. Create a European Stability Fund with at least €2tn of credit lines guaranteed by all Eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden and the UK. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically, but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the Eurozone.”

It’s unfortunate that policymakers – in Washington, Brussels, and pretty much everywhere else – ignored this suggestion until just now.  But this tells you a great deal about what it takes to change any part of our economic system.  It’s only in the face of great crisis and the potential breakdown of financial markets that US and European authorities are willing to act.

The good news is that change happens.  The bad news is that because leading governments are unwilling even to seriously discuss difficult economic scenarios (“too radical”, “don’t rock the boat”, “powerful interests are opposed”), when they bring in new policies there is a great deal of improvisation and major mistakes are entirely possible.  “Change only when we must” is a dangerous approach – see Hank Paulson in September 2008 (Lehman allowed to fail; AIG “saved” after a fashion; TARP proposed without any oversight, etc.)

And this is exactly why our seriously dysfunctional megabanks – in the US and in Europe – are not being “fixed”.  When the crisis breaks, people like Tim Geithner and Larry Summers say it would be too dangerous to even fire some boards of directors, let alone change CEOs in top banks.  The anti-crisis improvisations focus in Europe – as they did under Mr Geithner’s direction here – on “just save the big banks, as is.”

But after you save the banks, they again become so politically powerful that they fight hard to block serious reform.  They already turned back the effort to really limit their scale – the Brown-Kaufman amendment, defeated last week.  And now they are striving to prevent effective restrictions on their scope – the Merkley-Levin amendment (supported in principle by Paul Volcker, the White House, and the president, coming up this week): press release; amendment text; WSJ story

If you don’t fix the system now, you’ll have another major crisis – and then you likely won’t fix the system again.

39 thoughts on “Our Eurozone Call In October 2008 And Banking Reform Today

  1. Unfortunately it will take another crisis which shuts down the credit markets before real structual reform will be accomplished. Human memory is short regarding financial crises.

  2. As Mohamed El-Erian said the other day (to slightly paraphrase) in an interview the best analogy for our current system is that we are driving a high powered car at high speed having used up all of our spare tires.

  3. I agree and I suggested an alternative way to start fixing the system at
    Moreover the issuance of EU bonds supported by a financial transaction tax or a tax on banks (to address also the systemic risk of bank and debt interconnectedness) should clear and simplify the web of intra-EU debt.
    On the other hand, the so-called “no-bailout clause” of the Maastricht Treaty specifically stated that the community would not assume the debt of individual EU member states. However the debt interconnectedness and the recent bailout package alter that clause in practice as well as any other EU balancing budget rule (it’s to be noted that actually the Pact’s rules have so far been weakly enforced).

  4. Globally, we seem to be trapped in a complex, such as Eisenhower described of the military industrialist and Congress. Yet today we now have a huge bank – government complex of money flows back and forth, crisis and consolidation, leading to ever greater ‘moral hazard’ and ever larger even less possible to fail institutions.

    Crisis do present opportunity but only with political will to move in the right direction will result in reform. Otherwise we will see more of ’08 with Paulson et al in the US and, I dare-say, today’s bailout of the big European Banks. These seem to be more of an opportunity for TBTF banks to get bigger, or at least collect large profits from gov’t largesse, rather than any movement toward real reform.

    “Hank Paulson in September 2008 (Lehman allowed to fail; AIG “saved” after a fashion; TARP proposed without any oversight”

    Paulson’s response was crude, but Imagine that perhaps policy makers have one primary motivation, fear: fear of losing their capital, and their corporations capital. Fear of upsetting the current order: the actions taken are exactly the actions you would expect if this was the case.

    I’m afraid that to enact the clearly most intelligent reform suggestions we find in these pages, it will take something greater than rational argument. It will take political will to move in the right direction, and that is something that won’t come without political empowerment of the people. So that politicians fear the people as much as they today fear the “banksters”.

    Unfortunately, just as we’ve seen banks consolidate in the last few decades, we’ve had a similar consolidation in the media, at least here in the US. This is the source of information for much of the public. Now that FCC regulations have been dismantled, today’s media does not face the tough questions. One extreme example, here in the US, News Corp’s Fox News seems to be little more than a corporate propaganda tool.

    So unless we can figure out ways to empower people, possibly through blogs like Baseline Scenario, I think the future holds some unpleasant outcomes. An end of the bailout and consolidation cycle, seems likely as the bailouts can’t last forever? This may bring a collapse of the bank-gov’t complex we see today, but what it will be replaced with without public participation, I shudder to think.

  5. Do I understand this correctly?

    For every $100 million in bonds … there could be $1 billion in credit default swaps hedged on the performance of these bonds. The money that a protection seller (insurer) would be required to pay out is backstopped by the government, in other words, hedged on future tax revenue. There are trillions worth of CDSs in the financial system. If this system collapses there will be a global Depression.

  6. Dear Simon,

    I am not sure I understand what the difference is between Greece and the other Eastern European (non-Euro) countries, that directly called in the IMF, restructured their debt and made budget cuts.

    Why is there any danger for the EURO if Greece defaults (or Portugal or Ireland for that matter)? It seems to me, people are scared about their money, politicians support that fear, and economists, well, do not do a good job explaining what the problem is…

    So WHY is all this a problem for the EURO?

  7. We are back to the questions:

    What is the role of government? What role does political economics play in government? Are citizens able to make informed decisions on the kind of government they want? Are politicians governing in the interest of “ordinary” citizens, ie, the 90% of people who earn less than $104,700 a year? (See: Pitchforks

  8. Even in that proposal, to transpose the Bagehot framework, I see the free lending hand, and perhaps the “penalty rates” are in the form of “austerity” (but only for the relatively blameless people, and many of them completely innocent, not for the criminal parasites who of course caused all the problems). I don’t see the good collateral.

    But even if all that made sense, it still fails because these are not solvent entities. The system as a whole and each of its higher-level parts are insolvent.

    So regarding this:

    If you don’t fix the system now, you’ll have another major crisis – and then you likely won’t fix the system again.

    That’s true, but “fixing” the system means dismantling it to a much lower level of complexity and centralization and higher level of sustainability.

    The only other option is letting it collapse to that level. In the absence of organized, constructive action, that’s inevitable and therefore the default. Therefore it’s the historically implicit goal of the Bailout.

    In itself the Bailout is purely destructive action, trying to prop up the unsustainable system as long as possible in order to loot as much as possible and preserve the wealth and power of the elites as long as possible, and doing it all at the intended cost of regression to feudalism and serfdom for 99% of the world, including the West.

    The Greek bailout and the ongoing Fannie and Freddie laundering scam are theaters of this Bailout War.

  9. Again, let me suggest: You can pull off all the fancy-schmancy “deals” in the world to try and make the mess look better on the outside…all the regs, all the oversight, all the credit lines, all the programs, hearings, commissions, proclamations, summits…

    …but it’s the inside that’s being ignored.

    The heart, the humanity, the ethics, the integrity, the character of our “leaders”…is vapid. Vapid, bankrupt, without morality, psychopathic. (I suggest reading up on the diagnosis of “aggressive narcissism” if you doubt such a conclusion.)

    Unless we as a nation look this squarely in the eye, and until we can, as commenter jfk noted, “figure out a way to empower people”…as we reclaim what it means to value, as mlk noted, “the content of one’s character”…

    …those at the top will continue just doin’ the dance until it all collapses. (Which, in the current environment, is just around the corner. And my guess is, anyone even half aware of what’s really going on…knows this. We know it.)

  10. Can you explain how someone can “create” shorts just like that? If you short a stock, it means you borrow it from your broker to sell it. Which means your broker must have the stock, or be able to get it somewhere. How can you just “create” short CDS? This is like printing “anti-money”, isn’t that too weird?

  11. Simon – there is no amount of money (in any currency) that will solve this problem. Your other remarks about reducing membership in the Euro is really key for long-term improvement. Part of the problem as I see it is that if these sovereign countries default on their (restructured) debt, there is no penalty. I think a key component of any loans that are made should be that the borrowing country must put up hard assets as collateral. If they do not wish to do this, they can withdraw back to their own currency and print up a storm if they want. At least then the problem is more contained. So why doesn’t the IMF tell Greece to put up, I don’t know, say the Acroplois or an island as collateral on each of their new bonds? Somehow I think they’d rather be out of the Eurozone that do that…..

  12. If they had followed the Johnson/Kwak suggestion, then the credit rating agencies would have seemed fit to award triple As to every country in Europe, and then the banks could have financed sovereign European debt with zero capital requirements and an infinite leverage… and Europe would have been even so much deeper in the hole it is.

    Johnson/Kwak must have some very close relatives in the Basel Committee, the way they keep from mentioning it, even though that Committee has provided the main growth hormones that turned big banks into “seriously dysfunctional megabanks”

  13. This is spot on. The problem is multi faceted and many of the facets are related to the nature and disfunctions of the individual and how those are supported by systems. I heard a neurologist speak not long ago about risk taking among teens, particularly as relates to sex. The upshot was that given the nature of their brains at that stage, the risks they take are perfectly rational. The payoff is big and immediate, statistically the risks are relatively small per event, and they can mostly be “fixed”. Where maturity comes in and results in different risk reward decisions is where the brain can zoom out and see the greater context, using a different type of thinking. Then there may be a different rational decision.

    Until we address the environment in which decisions are made and the pressures and rewards for the actor, we will solve little. We must have a new ethic and must use all tools including reducing the corporate shelter for individual wrongs so that real penalties such as criminal prosecution can be imposed.

  14. This is just another Joseph Stiglitz kind of proposal.
    Listen to: http://www.youtube.com/watch?v=Tt_JlPCkQSs

    In minute 55:50 you hear the Nobel prize winner saying: “What rate of return do we need to get on our investments in order for the tax revenues that we get from the short run growth and from the long run growth lead to an actual reduction in the national debt in the long run?; and the answer is a very low return, only about 5 to 6 percent return on public investments will lead to a long lower long term national debt; and the evidence is that the returns from investments for instance in public technologies are much-much higher…. so we should encourage public expenditure that yield returns.”

    And when we hear that, we shiver, because we know that he knows that this argument will be used to support expenditure that will not yield returns… but which is ok with his agenda. Somewhere in there Stiglitz refers to “when we hear those politicians talk” What a laugh!

  15. “And now they are striving to prevent effective restrictions on their scope – the Merkley-Levin amendment (supported in principle by Paul Volcker, the White House, and the president, coming up this week” – principles from the White House aka Pres Obama, Summers, Geithner, Romer, (and forgetting to mention in an earlier post) economic advisor Austin Goolsbee) – the obvious inference being, you don’t get voted into power on principles :-)

    Across the pond, they just throw banknotes at ’em: “A well-documented typical evening while [David] Cameron was a member in the late 1980s consisted of the members taking over one of Oxford’s fanciest restaurants for the night, eating the priciest food on the menu, ordering and quaffing copious quantities of the most expensive wines and champagnes — and then totally trashing and destroying the entire restaurant, furniture and fittings….”

  16. The Western world keeps spending its way to disaster

    May. 12, 2010 6:56AM EDT -Globe & Mail – excerpt

    “The Swiss-based Bank of International Settlements (BIS), the oldest international financial institution in the world, has functioned as the central bank of central bankers for 80 years. In a working paper written by three senior staff economists (“The future of public debt: prospects and implications”), released in March, BIS warns that Greece isn’t the only Western economy with hazard lights flashing.

    Indeed, it names 11 more: Austria, France, Germany, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, Britain – and the United States. Without “drastic measures,” BIS says, all of these countries will hit a wall of debt.

    When the senior economists at BIS warn 12 of the richest countries on Earth that they must take drastic action to reduce debt, you know that it’s time to check the air bags. The only thing you don’t know, that you need to know, is the precise time of the crash. The lesson is already obvious: Governments can’t drive recklessly, use only the accelerator for braking and not eventually crash.”


  17. What on earth would the IMF do with the Acropolis or an island? Or the Smithsonian, for that matter?

  18. CDS is a bet. Participants pay for probability of payoff. The market price is essentially a probability consensus. That is why you will see statements from time to time that “the market” or the “CDS market” shows a XX% probability of default in Y months.

    Like any market, if you sell something cheaper than the market price, you can make a sale.

  19. Russ, I couldn’t agree with you more. I’m just curious to know what kind of conversations politicians and bankers are having with their respective militaries as hoarding the wealth of the world is not enough. At the end of the day they will have to control the weapons and the soldiers too if they do not want to be drawn and quartered on the public square. How “failsafe” is the U.S. millitary against the kind of threat that is mounting? God knows the U.S. military is awfully big…you’d think big enough that it could easily fracture along the political ideologies of it’s top chain of command leading to some very complicated messes WITHIN the U.S., never mind, without.

    I’m afraid that what is unfolding is likely to tip the scales in favour of autocracy centered around corporate feudalism which historically have choice governing models for humans who quite clearly are not able to keep their animal spirits in check for the good of society. And where the corporatist tentacles cannot reach there will be Shariah law.

    It pains me to say that the democracies of the West cannot function in a world that depends on ever shrinking decision making horizons and grotesque levels of economic growth in order to sustain ever increasing levels of debt while choking the planet’s ecosystem to death. IT CANNOT CONTINUE. It simply goes against the laws of Nature and the only way the charade has been kept afloat has been by dazzling the masses with the debt driven illusion of wealth while the Elites have scrambled to keep the lights on in their Casinos.

    It could well be that 20th Century Man is about to be relegated to the dustbin by the digital natives who will throw in the towel on environmental conservation and throw all their intellectual might behind the science of becoming more machine than human. They will build a new economy based on developing biological interfaces with computers and pushing the boundaries of nanotech, robotics and synthetic body parts in the hopes of becoming all-out cyborgs no longer bound by Earthly needs such as oxygen, food, water, GRAVITY, but only electricity and synthetic lubricants. Space travel over inhuman distances will become possible. We will then be ready to seed the Universe. We are on the verge of the cyberpunk future. Dust off your old William Gibson novels and cue up Blade Runner if you want a sneak peak.

    There is no maintaining the status quo for it will not allow itself to be maintained. Either we defeat Nature definitively by using our industrial, computing and biological know-how to wean ourselves from her bosom or we must capitulate, retreat and figure out ways to move forward without raising her ire.

    The only thing that seems clear to me is that our planet can barely tolerate 6 billion people. To say that by 2050 there will 9 billion humans on Earth with a straight face is a crime against Reason. Our numbers are about to crash along with the exhausted, hollowed-out version of Capitalism that’s been clinging on for dear life a decade too long…. As much as I fear what is coming… I also embrace it. I don’t know if it will change we can believe in. But it will be change. And that’s a start.

  20. First, despite all the bad press, derivative markets do something useful: they allow risk to be easily transferred and shared. The size of the market at any time reflects market participant’s need to hedge their risks and speculation about the future direction of the market (which is not a bad thing, it helps with price discovery.) Also, there is no EXPLICIT guaranty of backstop by any government.

    The problem is not the CDS market, per se, it is the fact that TBTF banks are in a position that when they are in trouble the government must bail them out because a failure of a TBTF banks will bring down the entire economy. Add in the political power that they have via their excess profits, and the “revolving door” (executives moving between banks and government) and the certainty of bailout becomes high enough influence the risks that they take.

  21. Steve,
    You’re right, its rare to see an explanation of the connection between bank credit and the Euro. Europeans have a better understanding because they live under the Euro system. Have a look at wikipedia.

  22. NOTE: It is a bit flippant to say that Goldman can create shorts faster than Europe can print money. It sounds so easy and plays on people’s fears and distrust but in fact such a huge speculative bet is very risky and is unlikely to be done on a whim.

  23. I don’t understand the relationship between a CDS and going short.

    A CDS is not a short, it is a simple bet. It is synthetic.

    If the CFS is hedged, it then does relate to something tangible.

  24. The euro is at risk from Euro bailouts for the same reason the US dollar is at risk from US bailouts.

    New euros are printed to pay off debt rather than allow it to go into default. More euros equal less value for the euro.

  25. No coincidence that “Baseline Scenario” is an anagram of “Basel Core Asinine”.

  26. This is confusing. The more recent proposal seems most logical to me. Propping things up at artificial prices never lasts.

    October 2008: “2. Create a European Stability Fund with at least €2tn of credit lines guaranteed by all Eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden and the UK.”

    May 7, 2010: “But be wary of committing official resources too early in this market downdraft – smart policymakers will calmly let the markets fall further, in order to benefit from the rebound potential.”

  27. Someone must take the other side of a CDS contract bought by GS. GS buys a payoff. Who would take such a contract in the amounts discussed? Even $1 trillion let alone $10 trillion. Of course, the big banks could conspire to take these contracts so that they can gamble that they have more winning positions than losing positions knowing the governments will bail out those that net lose. Thus, they are guaranteed payment by the state.If things are this far gone…… does it even matter what is discussed about the system?

  28. This sounds nice, but the real reason that these risks need to be transfered and shared is that market participants are making bets beyond their bankrolls.

    That would be fine if these participants didn’t bring their losing tickets to the taxpayer’s cashier window.

    And, let’s not confuse this type of the insurance with say, home or health insurance. You need a roof over your head and your health can sometimes be beyond your control, but no one needs to make huge speculative bets.

  29. The European’s have been taught a valuable,and painful lesson. Their capitulation was predictable when some became arrogant,and greedy? Yes,Greedy! How dare they encroach on the century old establishment of,”The Money Changer’s”! It was a system,”Designed to Fail”,period – as the “Money Changer’s” sat back (decade?),and inflated the Euro to unsustainable levels. Oh,…how they’ve savored this moment in time to come too fruition. So sweet is the taste of victory, flavored with a searing vengence too teach these renegades an unforgetable lesson of obedience. The “Money Changer’s” rule in Europe, as they have throughout the world for millenium! Thanks

  30. The scenario JerryJ describes is plausible if brokers got to collect their fees and bonuses even if the LLP they worked for ended up a net loser. It does not matter if the government would, or would not, bailout their LLP. This already happened with Lehman’s and AIG.

  31. E.U. Plans Peer Review for Member States’ Budgets

    May 12, 2010 – New York Times – excerpt

    BRUSSELS — “Seeking to capitalize on the momentum generated by Europe’s huge rescue plan for its single currency, the European Commission on Wednesday outlined ambitious proposals to give countries that use the euro a say over each other’s budget plans.

    Proposing the most far-reaching integration ever envisaged for the 16-country single-currency zone, the European Commission president, José Manuel Barroso, warned Europeans that they “can’t have monetary union without having economic union.”

    “Member states should have the courage to say whether they want an economic union because, if they don’t want that, it is better to forget monetary union altogether,” Mr. Barroso said at a press conference in Brussels.

    Among the ideas announced Wednesday was a plan to make the huge safety net for the euro that was decided on over the weekend a permanent crisis-resolution mechanism.

    The European Commission, the executive agency of the European Union, also argued that the current E.U. focus on budget deficits should be broadened so that, for example, emerging asset bubbles and imbalances in the euro zone could be spotted and dealt with.

    Fears of a default in Greece and contagion within the single currency ultimately required France and Germany to overcome their differences and agree on a €750 billion, or $950 billion, bailout package, backed by the euro-zone countries and the International Monetary Fund.

    Olli Rehn, the European commissioner for economic and monetary affairs, said Wednesday that the economic “good times were not used for reducing public debt, and macroeconomic imbalances were ignored.”

    The revised system would mean that national spending plans would be examined by all euro-zone countries before they are approved — a step likely to prove highly controversial. After a recommendation from the European Commission, E.U. governments could issue warnings if a country was thought to be pursuing irresponsible policies.”

    * Good luck with that.

  32. Mr. Johnson wrote:

    “If you don’t fix the system now, you’ll have another major crisis – and then you likely won’t fix the system again.”

  33. My next area of concern would be China. Some pundits suggest that China would need most of it’s capital reserves to sterilize their banking system in the event of a the commercial real estate market blowing up – an event that would drag down Europe.

  34. There is, after all, a very good reason why the latest measure is being widely disparaged as the European TARP. This will only create a bit of breathing space, followed by a hugely ponderous and painful restructuring of the Eurozone, with lots of losers and but a few winners amongst its present country membership. The most benefit will go to the large banks in the prosperous nations. The most pain will go to everyone else, but mostly, as in America, the average citizens of all of the countries.

  35. British face big spending cuts as coalition shows unity on austerity

    May. 12, 2010 9:53PM – Globe & Mail – excerpt

    “With Conservatives at the helm of fiscal policy, government plans to slash £6-billion in public outlays. Britain’s new government is ushering in an age of austerity by making its opening move in what will be a long and difficult struggle to contain its soaring deficit.

    Faced with the type of mounting deficits haunting its European neighbours, the coalition led by new Prime Minister David Cameron affirmed Wednesday that it will forge ahead with £6-billion ($9-billion) in public spending cuts this fiscal year. But these promise to be only the first of a series of deep, painful and politically unpopular cutbacks – and eventual tax hikes – as Britain seeks to get its messy fiscal house in order.

    The cuts could hamper the fitful recovery of the world’s sixth-largest economy from the worst recession since the Second World War, but are regarded as essential if the country wants to avoid the slashed bond ratings, loss of investor confidence and soaring interest costs afflicting some members of the euro zone.”


  36. No doubt that the big banks are no longer serving a socially valuable function. Please keep up the pressure for reform.

    Two additional points:

    First, most of the money in the world is OURS! I saw a presentation a few months ago which detailed to movement of money during the credit crisis – from memory, the numbers were $40 trillion in Retirement Savings, and $20 trillion from Hedge Funds & sovereign wealth funds, and $20 trillion from miscaelaneous. So, how come it isn’t being managed to further our interests?

    Second, the EU seems to have taken some of Simon’s comments to heart. It looks like the EU is going to progress from just a monetary union to a fiscal union. See http://www.telegraph.co.uk/finance/financetopics/financialcrisis/7716530/EU-imposes-wage-cuts-on-Spanish-Protectorate-calls-for-budget-primacy-over-sovereign-parliaments.html

    But the bottom line is still productivity. Countries as well as people have to produce more than they consume – or, if you wish, have to limit their consumption to their productivity. And I can’t see how a country like Greece is going to boost its productivity while hamstrung with austerity measures such as its’ 23% VAT.

    Scary future, particularly if we can’t reform the banks.

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