By Simon Johnson
The idea that big banks damage the broader economy has considerable resonance on the intellectual right. Tom Hoenig, recently retired president of the Kansas City Fed, has been our clearest official voice on this topic. And Gene Fama, father of the efficient markets view of finance, said on CNBC last year, that having banks that are too big to fail is “perverting activities and incentives” in financial markets – giving big financial firms, “a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”
The mainstream political right, however, has been reluctant to take on the issue. This changed on Wednesday, with a very clear statement by Jon Huntsman in the Wall Street Journal on regulatory capture and its consequences. Before the 2008 financial crisis: “The largest banks were pushing hard to take more risk at taxpayers’ expense.” And now,
“More than three years after the crisis and the accompanying bailouts, the six largest American financial institutions are significantly bigger than they were before the crisis, having been encouraged to snap up Bear Stearns and other competitors at bargain prices. These banks now have assets worth over 66% of gross domestic product—at least $9.4 trillion, up from 20% of GDP in the 1990s. There is no evidence that institutions of this size add sufficient value to offset the systemic risk they pose.”
This message could work politically, for five reasons.
First, for anyone on the right of the political spectrum who thinks at all about the issues, this is a coherent and appealing position. Fama had it exactly right when he said, in the same interview: “[Too Big To Fail] is not capitalism. Capitalism says – you perform poorly, you fail.”
“Too big to fail” is not a market; it’s a government subsidy scheme – of the most inefficient and dangerous kind.
This is exactly Huntsman’s theme: “Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality.”
Second, senior serious figures within the Republican Party have long been pointing in this direction. In 2009, for example, Nicholas Brady said: “First we should just come out and say it: the financial system that led us to the brink of disaster is broken.” George P. Schultz has emphasized that we should “Make Failure Tolerable”, for example, “an escalating schedule could be required of necessary capital ratios geared to size and matched with escalating limits on leverage.”
Republicans like to discuss who is and is not a true Republican. How can any “true” Republican really condone the subsidies that underpin our biggest financial firms today?
Third, mainstream financial thinking is in exactly the same place, in terms of arguing that capital requirements for big banks should be much higher. On this issue I refer you, as always, to the work of Anat Admati and her colleagues at Stanford University.
Huntsman’s position is in alignment with the strongest possible technical thinking, but he has also found a direct and easy to communicate the right political message. Higher capital requirements for big banks are a great idea – this should help prevent financial disaster. But when such disaster occurs, we need financial institutions that can actually fail – with losses to creditors – without bringing down the entire system. Anything that is Too Big to Fail is simply just too big.
Fourth, political Republicans who favor the status quo with regard to megabanks are going to have hard time justifying that position – including in a confrontational debate format. In particular, Mitt Romney is very vulnerable on this issue – particularly as he has already lined up so much support from among biggest banks.
Presumably the prospect of Wall Street donations is enough to deter some Republicans (and many Democrats) from really confronting the issue of Too Big To Fail. But if Romney is already far ahead is this fund raising category, there is much less to lose. And his donations must make it harder for him to explain exactly how he would ensure that even one mega-bank could fail.
It’s not enough to just wish that big banks could fail – or to promise not to support them “next time.” This is not a credible commitment – and the “resolution authority” created under the Dodd-Frank reform legislation is a complete paper tiger with regard to winding down the biggest banks. If the choice is global economic calamity or unsavory bailout, which would you choose – let alone any Republican president?
Huntsman has joined the dots. There are various ways to directly address and remove the implicit subsidies that the largest banks receive – bloated size and excessive leverage can be effectively taxed.
“Eliminating subsidies would encourage the affected institutions to downsize by selling off certain operations or face having to pay the real costs of bailouts. We need banks that are small and simple enough to fail, not financial public utilities”.
Fifth, the eurozone is on the verge of calamity in large part because they built very large banks with huge implicit subsidies – and this facilitated an irresponsible accumulation of public sector debt.
During the Dodd-Frank financial reform debate last year, we heard repeatedly from people – including senators on both sides of the aisle – who believed that reducing the size of our largest banks would somehow put the rest of our private sector at a disadvantage.
Who now would like to emulate in any way the disaster that the Europeans have brought upon themselves? Seriously, Mr. Romney, please explain how you would prevent our largest banks from becoming ever larger and taking on more risk – and supporting the reckless build-up of debt throughout the global economy?
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.