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The Economy: Why They Failed

Paul Volcker; drawing by John Springs

From an economic viewpoint, the most serious problem with the rescue programs was not that they further enriched the loathed bankers but that they exacerbated some serious incentive problems at the heart of the financial system. By extending trillions of dollars in loans, capital injections, and debt guarantees to troubled firms, the US government and its counterparts overseas had greatly extended the public safety net for banks and other financial entities. Left unchecked, this expansion will surely lead to more blowups, followed by even bigger bailouts.

The problem is one of rational irrationality. Once people in the financial sector come to believe that the government will cap their losses, they have an incentive to step up their risk-taking, what is called “moral hazard.” Simply announcing that there won’t be any more bailouts won’t solve the problem, a point noted by two Bank of England economists in an important paper published in November 2009. Policymakers may say “never again,” wrote Andrew Haldane and Piergiorgio Allesandri,

but the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.1

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed in July 2010, while containing many worthwhile individual measures, didn’t really get to grips with this problem. Taken overall, the reform effort amounts to tinkering with the existing system rather than fundamentally reforming it. Any comparison with FDR’s regulatory response to the Great Depression is specious. By the end of Roosevelt’s first term, the financial system had been transformed. The House of Morgan and other big banks had been split up into their investment banking and commercial banking components; through the newly founded SEC, the government was exercising close supervision of Wall Street; through the Reconstruction Finance Corporation, which had acquired and kept equity stakes in many big financial firms, it was forcing reluctant bankers to extend credit; and through the Justice Department, it was prosecuting a number of prominent financiers. Today the financial system looks overall pretty much the same as it did in 2007, even though at the end of 2010 there are fewer independent Wall Street firms than there were a few years ago, and the survivors have a bit less freedom to maneuver than they used to have.

Overseas, the same is true. For all their attacks on American free-market dogmatism, European and Asian governments have shown little inclination to clean up their own financial systems. The big European countries, in particular, which have a lot of big multiservice banks, lobbied strenuously against any attempt to break them up. On the torturous issue of bank capital requirements, something similar happened. By September 2010, when new capital standards were announced, they were so modest that many big banks, having replenished their coffers, already satisfied them.

Here in the United States, after all the mergers that the government had orchestrated during the crisis, six huge firms—Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo—now dominate the financial industry, wielding enormous market power and political influence. Together, their assets come to about 63 percent of GDP, some $9.2 trillion. The ratings agencies remain unreformed, and so do some of the myopic compensation packages for Wall Street traders and CEOs that helped bring on the crisis. The one really innovative idea that the administration had was to impose a hefty “pollution tax” on the risk-taking of financial institutions, which would have increased in proportion with their balance sheets. But it didn’t feature in the Dodd-Frank reform bill and has faded from view.

After all that had happened, the measures actually taken—forcing financial institutions to maintain more capital, shifting derivatives trading onto exchanges, and setting up a new agency to protect consumers from predatory lenders—were the least that could have been done. And even in those matters, the Dodd-Frank bill contained a number of sops to the financial lobby. The big US banks still don’t face any hard limits on the amount of debt they can take on; neither do their international competitors, such as Barclays, Deutsche Bank, and UBS. A significant but undetermined amount of derivatives trading is exempt from the new regulations, and the issuance and trading of naked credit default swaps—bets that a certain company or country will go bankrupt—remain perfectly legal. The new consumer protection bureau, rather than operating as a stand-alone body, in the manner of the Food and Drug Administration and the Environmental Protection Agency, is housed inside the Fed, an institution that failed abjectly in overseeing the mortgage market. (Confirming the old adage that nothing succeeds like failure, the Fed was also given new power to act as a “systemic risk regulator,” overseeing the activities of the biggest banks.)

During the debate on Capitol Hill, it is true, some steps were taken to toughen up the reform bill of Christopher Dodd and Barney Frank, notably the inclusion of the so-called Volcker Rule, which prohibits banks from proprietary trading and places limits on how much money they can invest in hedge funds and private equity funds. Depending on how this directive is enforced, it could prompt Goldman and Morgan Stanley to give up the commercial banking licenses they acquired in 2008 and revert to being investment banks. Bank of America, Citi, JPMorgan, and Wells, which are much more invested in commercial lending, will have to scale back their proprietary trading desks. Citi has already done so. (As of now, both Goldman and Morgan Stanley appear determined to keep their banking licenses. To that end, they have been letting go of some proprietary traders and reassigning others.)

Former Fed chairman Paul Volcker’s laudable idea, which the White House adopted at the start of 2010, was that nondepository institutions shouldn’t be allowed to shelter under the government safety net, and, legally, at least, they won’t be able to. The US government now has the power, during a crisis, to take them over and close them down. (At the time of the collapse of Bear Stearns and Lehman Brothers, this authority was lacking.)

However, it is one thing to empower the Treasury and the Federal Deposit Insurance Corporation to fire senior bankers, wipe out stockholders, and impose losses on creditors. It is quite another thing for the authorities to exercise these powers. If Goldman, say, was to run into serious trouble shortly after giving up its banking license, it is hard to believe that the Treasury and Fed would shut it down and let the dominoes fall where they may. If markets were plummeting and creditors, depositors, and other counterparties were rushing to liquidate their positions, the authorities would come under enormous pressure to prop up the firm, or find a healthier rival to take it over. Then we would be back to September 2008.

Despite the best intentions of Volcker and others, the big six banks and an undetermined number of other financial firms are almost certainly still too big to fail. Taxpayer rescues of systemically important institutions can’t be legislated away: the real issue is what can be done to reduce the likelihood that such measures will be needed. Apart from regulating individual lines of business that involve big risks, a tricky enterprise in the best of times, the options are either to greatly reduce the leverage that banks can take on or to break them up, so the failure of any one of them would no longer pose an insurmountable risk to the system.

Neither of these ideas is exactly revolutionary. Practically everybody agrees that excessive leverage played a key role in the crisis, and the idea of splitting up the largest banks has won the support not just of progressive economists but of the British Conservative Party, which formed a coalition government in May 2010; of Mervyn King, the governor of the Bank of England; and even of Alan Greenspan, the former Fed chairman. If the banks are “too big to fail, they’re too big,” Greenspan said in October 2009, and he went on to say, “In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

But far from insisting on drastic reductions in leverage and smaller banks, the Obama administration connived against measures designed to bring these changes about. Senator Susan Collins, of Maine, and Senator Blanche Lincoln, of Arkansas, both proposed amendments to the Dodd-Frank bill that would have forced the biggest banks to hold substantially more capital—and real capital, not hybrid securities that are more like debt. After the Senate passed the Collins and Lincoln amendments, the White House and Treasury pushed Congress to drop them from the final legislation. A move to break up the biggest banks, such as Wells Fargo and Bank of America, which was sponsored by Senator Ted Kaufman, of Delaware, and Senator Sherrod Brown, of Ohio, didn’t even get that far. The Democratic leadership in the Senate joined with Republicans to kill the amendment, which was voted down 61–33. “If we’d been for it, it probably would have passed,” a senior Treasury official told New York magazine. “But we weren’t, so it didn’t.”

Utopian economics is on the defensive, just like it was in the 1930s, but it is too early to hail the triumph of reality-based economics. For one thing, the political environment is very different from the one that Roosevelt and Keynes operated in. During the Great Depression, many of the unemployed went hungry, and there was real desperation: it was widely accepted that free-market dogma had failed and that the authorities should step in to put things right. Despite its global scope, the Great Recession doesn’t really compare with the Great Depression, and many ordinary people remain suspicious of government interventions to correct market failures.

Indeed, the summer of 2010 saw a powerful reaction against Keynesian deficit spending. On both sides of the Atlantic, there were calls for an end to stimulus programs; in Germany and Britain, the center-right coalition governments of Angela Merkel and the newly elected David Cameron moved to cut public spending and raise taxes. Partly a reaction to the Greek debt crisis, this policy turnaround also resurrected the “Treasury view” of the late 1920s and early 1930s, which saw the main threat to economic recovery not as a shortage of overall demand but as a dearth of confidence in the public finances on the part of businessmen and investors. With the triumph of Keynes’s “General Theory,” this argument had seemingly been consigned to history, but here it was again, modified hardly at all, on the lips of conservatively minded economists, commentators, and policymakers. “Germany has never agreed to an austerity package to this extent, but these cuts have to be made in order for the country to establish a stable economic future,” Chancellor Merkel said in announcing the German budget cuts.

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    Banking on the State,” available at bankofengland.co.uk

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