The G20’s China Bet

By Simon Johnson

The G20 communiqué, released after the Toronto summit on Sunday, made it quite clear that most industrialized countries now have budget deficit reduction fever (see this version, with line-by-line comments by me, Marc Chandler and Arvind Subramanian). The US resisted the pressure to cut government spending and/or raise taxes in a precipitate manner, but the sense of the meeting was clear – cut now to some extent and cut more tomorrow.

This makes some sense if you think that the global economy is in robust health and likely to grow at a rapid clip – say close to 5 percent per annum – for the foreseeable future. With high global growth, it will matter less that governments are cutting back and unemployment will come down regardless. Taking this into account, the IMF is actually predicting (as cited prominently by the G20) that budget “consolidation” actually raise growth over a five-year horizon.

There is no question that some weaker European countries, such as Greece, Portugal, and Ireland, had budget deficits that were out of control. Particularly if they are to pay back all their foreign borrowing – a controversial idea that remains the conventional wisdom – these countries need some austerity. But what about those larger countries, which remain creditworthy, such as Germany, France, the UK, and the US? If these economies all decide to reduce their budget deficits, what will drive global growth? Continue reading “The G20’s China Bet” →

The Private Sector Fallacy

By James Kwak

Felix Salmon highlights an important point to bear in mind when it comes to banks and short sales. Actually, it’s an important to bear in mind when you’re thinking about any big private sector company, be in Citigroup or British Petroleum. Yes, companies do things in their own self-interest that hurt other people and may not be net benefits to society. But they also do things that are not in their own self-interest all the time, because companies just aren’t all that efficient.

Felix’s post is largely about two factors. One is that big company executives are prone to exactly the same sort of cognitive fallacies as ordinary people, and hence make stupid decisions routinely. The second is that the incentives of individual people who make decisions (or provide information to people who make decisions) are only tangentially related to the interests of the company as a whole, and certainly not when you think of those interests over the long term.

A third factor is simply that companies are big, dumb, poorly designed institutions. There’s lots of talk about how individual human beings do not resemble the rational actors of textbook economic theory. The same is at least as true of big companies, of which I have seen many, from various perspectives.

Yet the belief that the private sector is the answer to all our problems remains deeply rooted. One might even call it an ideology. I would hope that the financial crisis (and the BP disaster) might cause people to question that ideology, at least a little bit.

What Is Goldman Sachs Thinking?

By Simon Johnson

The next financial boom seems likely to be centered on lending to emerging markets. Sam Finkelstein, head of emerging markets debt at Goldman Sachs Asset Management, summed up the prevailing market view – and no doubt talked up his own positions – with a prominent quote in Monday’s Financial Times (p.13, front of the Companies and Markets section):

“Debt-to-GDP ratios in the developed world are about double those in emerging markets and they’re growing. This makes emerging markets interesting because you’re pick up incremental spread [higher interest rates compared with developed world rates], and in return you’re actually taking less macroeconomic risk.”

This is a dangerous view for three reasons. Continue reading “What Is Goldman Sachs Thinking?” →

JP Morgan Responds To Financial Reform: The Poison Pill Strategy

By Simon Johnson

While the financial reform negotiation process grinds to its meaningless conclusion, the real action lies elsewhere – in Jamie Dimon’s executive suite.

Dimon, the head of JP Morgan Chase, is apparently seeking to (a) become more global, (b) move further into emerging markets, and (c) become more like Citigroup.

This is terrific corporate strategy – and very dangerous for the rest of us. Continue reading “JP Morgan Responds To Financial Reform: The Poison Pill Strategy” →

Tim Geithner and Larry Summers Need Paul Krugman To Replace Peter Orszag

By Simon Johnson. Tim Geithner and Larry Summers are talking a good game on fiscal policy to the G20. But they are struggling with to establish traction for their “spend now, consolidate later” message. Fortunately, there is an easy and obvious opportunity to establish credibility on this issue: Bring Paul Krugman into government.

Earlier this week, Peter Orszag resigned from his cabinet position as director of the Office of Management and Budget. The Washington Post put out one of the first lists of candidates who could replacement him. Senator Byron Dorgan would be a smart pick and some of the Post’s other suggestions could make sense.

But surely the front runner is Jason Furman. The working assumption is that Treasury Secretary Tim Geithner and National Economic Council director Larry Summers are in positions of influence for the long haul – and they have a track record of preferring team players over people who could bring competing perspectives to the table.

The Hamilton Project, housed at the Brookings Institution, was designed as a government-in-waiting by Robert Rubin. Then-Senator Obama attended its inaugural public meeting, with Peter Orszag as head of the project. Appointing Furman, successor to Orszag at Hamilton and currently a deputy to Larry Summers at the NEC, or another person from the same wing of the Clinton administration would continue in this tradition.

This is unfortunate, because the brilliant choice would be Paul Krugman – completely taking the wind out of the Republicans’ sails on fiscal deficits. Krugman has scolded them, in real-time and to great effect, consistently with regard to ruining the budget. And he has an important point – the Bush administration inherited a fairly sound fiscal position from the Clinton administration but squandered it thoroughly over 8 years. Continue reading “Tim Geithner and Larry Summers Need Paul Krugman To Replace Peter Orszag” →

“Chuck Prince” Is Going To Run This Bank (Into The Ground)

By Simon Johnson

“Breaking up big banks would actually increase system risk” is a refrain heard from top administration officials, ever more vocal after they helped kill the Brown-Kaufman amendment (that would have limited the size and leverage of our largest banks) on the floor of the Senate.

But while Mr. Geithner and his colleagues are still taking their victory laps and congratulating themselves on retaining “business as usual” after the biggest crash-and-bailout in world financial history, educated opinion starts to feel increasingly uncomfortable.

People who worry seriously about system risk break the problem down into several distinct buckets, including the nature of shocks and the way these are propagated across the system. In this typology, the “Chuck Prince problem” is in a class of its own. Continue reading ““Chuck Prince” Is Going To Run This Bank (Into The Ground)” →

Paul Krugman For OMB

By Simon Johnson

The president should nominate Paul Krugman to replace Peter Orszag as director of the Office of Management and Budget (OMB). (Orszag resignation details are here.)

We have previously reviewed Krugman’s outstanding qualifications for this (or any other top level) job (link to details). The main reason Krugman himself has been reluctant in the past relates to a potentially difficult Senate confirmation hearing – for example, if Krugman had been put forward to replace Ben Bernanke.

But for the OMB position, the dynamic of a hearing would be terrific for the president’s specific agenda and broader messages. Krugman, of course, is the leading advocate for continued (or increased) fiscal stimulus. This is exactly President Obama’s message to the G20 this weekend. Continue reading “Paul Krugman For OMB” →

Dead On Arrival: Financial Reform Fails

By Simon Johnson

The House-Senate reconciliation process is still underway and some details will still change. But the broad contours of “financial reform” are already completely clear; there are no last minute miracles at this level of politics. The new consumer protection agency for financial products is a good idea and worth supporting – assuming someone sensible is appointed by the president to run it. Yet, at the end of the day, essentially nothing in the entire legislation will reduce the potential for massive system risk as we head into the next credit cycle.

Go, for example, through the summary of “comprehensive financial regulatory reform bills” in President Obama’s letter to the G20 last week. Continue reading “Dead On Arrival: Financial Reform Fails” →

G-20 Rules; Time for Germany-Bashing

This guest post is by Arvind Subramanian, senior fellow at the Peterson Institute for International Economics.

Yesterday’s announcement by China to introduce greater exchange rate flexibility is unambiguously good news. Greater currency flexibility will help China with its domestic overheating problem. But China deserves a lot of credit for its act of responsible international citizenship, for making its contribution to global re-balancing. Two implications follow.

First, the G-20 deserves a lot of credit for the change in China’s policy. True, Secretary Geithner played his cards skillfully, balancing private chiding with public encouragement. It is also true that recent sabre-rattling by the US Congress to impose trade measures against Chinese exports may have played a role in persuading China. But it is the fact of the G-20 that allowed Secretary Geithner to convert the China currency issue from a bilateral US-China matter (on which little progress had been made for many years) to one in which a broader set of countries had a stake. The public pronouncements by Brazil and India earlier this year re-inforced this “multilateralization” of China’s currency undervaluation. This multilateralization had two positive effects. It forced China to take more seriously the international consequences of its currency policy. And it also made the politics of changing policy easier because China is seen not as caving to bilateral pressure but as responding to the wider international community. Regardless of what happens at the G-20 Summit in Toronto over this week-end, the G-20 can already count the change in China’s currency policy as its victory. Continue reading “G-20 Rules; Time for Germany-Bashing” →

It’s Not a Bailout — It’s a Funeral

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

In poetry and politics, metaphor matters. Expect some fighting figures of speech on Thursday, when the conference committee takes up the topic of the Orderly Liquidation Fund or “OLF.” Under the proposed financial reform legislation, the OLF is the facility that would hold the money needed by the FDIC to shut down a systemically important, insolvent financial institution before its failure can contaminate other firms and the broader economy. In other words, one purpose of the resolution authority and OLF is to avoid repeating the disorder and disruption of either the Lehman bankruptcy or the AIG bailout.

To be clear, many question whether regulators will have the courage to invoke this provision and pull the plug on a dying bank. Accordingly, the “prevention” measures under discussion in the legislation are critical — these included the swaps desk spinoff, hard leverage caps on financial firms, regulatory oversight over shadow banks and inclusion of off-balance sheet transactions in capital standards, among others.

One of the hottest debates concerning funding the OLF is over who should pay into the fund and when should they pay. On the question of “who,” the choices have been framed as either industry or taxpayers. And the “when” options are described as in advance of or after a failure. Many, including the House majority in its bill and FDIC Chairman Sheila Bair, support an up-front assessment on industry. Those who oppose an industry pre-fund have tried to damn the OLF as a “bailout fund” and at times the financial reform legislation as a “bailout bill.”

Continue reading “It’s Not a Bailout — It’s a Funeral” →

Why “Living Wills” Fail

By Simon Johnson

A central idea in the financial reforms currently undergoing final negotiation in the United States – and also in similar initiatives in Europe – is that large banks must draw up “living wills” that should explain, in considerable detail, how they will be wound down in the event of future failure.

The concept is appealing in theory. No one knows their business better than the banks, the reasoning goes, so they should have responsibility for explaining how they can close down their various operations – or perhaps sell more valuable parts while limiting losses for unprofitable activities. This is often presented as “smart regulation”, with government regulators requiring private sector experts to do the difficult technical work.

Tuesday’s hearing of the House Energy and Commerce Committee shed considerable light on why living wills are highly unlikely to work in practice. The hearing was actually about the oil industry – and its government-mandated plans to deal with oil spills. The committee posted the spill response plans for the Gulf of Mexico of five companies – BP, Chevron, ConocoPhillips, Exxon Mobil, and Shell – which demonstrated striking, peculiar and disconcerting similarities. Continue reading “Why “Living Wills” Fail” →

After “Financial Reform”

By Simon Johnson

Informed opinion is sharply divided about how the next 12 months will play out for the global economy. Those focused on emerging markets are emphasizing accelerating growth, with some forecasts projecting a 5% increase in world output. Others, concerned about problems in Europe and the United States, remain more pessimistic, with growth projections closer to 4% – and some are even inclined to see a possible “double dip” recession.

This is an interesting debate, but it misses the bigger picture. In response to the crisis of 2007-2009, governments in most industrialized countries put in place some of the most generous bailouts ever seen for large financial institutions. Of course, it is not politically correct to call them bailouts – the preferred language of policymakers is “liquidity support” or “systemic protection.” But it amounts to essentially the same thing: when the chips were down, the most powerful governments in the world (on paper, at least) deferred again and again to the needs and wishes of people who had lent money to big banks.

[to read the rest of this article, on Project Syndicate, click here]

They’re Just Irrational?

By James Kwak

Don’t get me wrong: I like behavioral economics as much as the next guy. It’s quite clear that people are irrational in ways that the neoclassical model assumes away, and you can’t see human nature quite the same way after hearing Dan Ariely talk about his experiments on cheating. But I don’t think cognitive fallacies are the answer to everything, and I don’t think you can explain away the myriad crises of our time as the result of them, as Richard Thaler does in his recent New York Times article.

Like many people, Thaler wants to write about the parallels between the financial crisis and the BP oil leak. For Thaler, the root cause of both crises is that “people in general are not good at estimating the true chances of rare events, especially when human error may be involved” — catastrophic market seizures in the first case, catastrophic oil rig explosions in the latter case.

I have no doubt that it is true that people have problems estimating the chances of certain rare events.* But to stop there is to whitewash the sins of the companies and the executives who created these crises.

Continue reading “They’re Just Irrational?” →

Don’t Forget The Kanjorski Amendment

By Simon Johnson

Substantive discussion in the House-Senate financial reform reconciliation conference is focusing on the Lincoln amendment, with some back-and-forth on the Volcker Rule (as manifest in the Merkley-Levin amendment). The FT reports today that Paul Volcker is no longer opposed to the Lincoln approach – now it has become clear that this is really just about (substantially) raising the capital that banks need to back derivatives trading. And the influential Tom Hoenig, of the Kansas City Fed, appears to be strongly in the Lincoln camp.

While our most experienced regulators weigh in, the lobbyists start to struggle. The mobilization of broader support against gutting the legislation also helps – the earlier Senate debate has raised sensitivity levels and there is a new concentration to the public scrutiny. The reconciliation process itself is much more open than would ordinarily be the case – a result of outside pressure.

But amidst all this excitement and potential moving parts, don’t forget about the Kanjorski amendment (not currently on the list of most prominent topics). Continue reading “Don’t Forget The Kanjorski Amendment” →

Why Section 716 is the Indispensable Reform

By Jane D’Arista

This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER). She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

Continue reading “Why Section 716 is the Indispensable Reform” →