THE FINANCIAL SYSTEM : HEADING FOR MORE TROUBLE / PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS ( VERY HIGHLY RECOMMENDED READING )

Peterson Perspectives

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The Financial System: Heading for More Trouble

Simon Johnson argues that President Obama’s proposed bank tax is a step forward but that the financial system is still distorted by flawed incentives.

Edited transcript, recorded January 15, 2010. © Peterson Institute for International Economics.

Steve Weisman: What does the United States do about banks and financial institutions that are believed too big to fail?

This is Steve Weisman at the Peterson Institute for International Economics with Simon
Johnson, senior fellow at the Institute, professor at MIT, and blogger extraordinaire on this
subject. Welcome, Simon.

Simon, this week the Financial Crisis Inquiry Commission heard from a lot of the marquee names in banking on that very issue. You’ve been addressing this yourself for many months. Have we moved the ball with their testimony and with some new proposals for bank taxes and the discussion in Congress about compensation?

Simon Johnson: Yes, the ball has moved; the ball is moving, I think, in the right direction. There is now recognition, really, for the first time this week I would say, Steve, from the top level, from the president himself, that we have a problem with reckless risk taking in our financial system, particularly by the biggest banks.

So the tax, which I’m not a huge fan of for various reasons, but it’s skewed toward the biggest firms, which is sensible, and it’s skewed toward the firms that take the most risk—the investment banks, if you like, rather than the
boring old state commercial banks, which is also a sensible principle. So, now we’ve started to move, the question is how far can we go and how quickly.

Steve Weisman: One interesting thing to me about the testimony was that all of the leading banking
executives who testified agreed that there should not be financial institutions that are too big
to fail. But did they offer any particularly interesting approaches to how to deal with that?

Simon Johnson: No. But you put your finger on a key point there, Steve, which is exactly that: Nobody can come out and say in public, “too big to fail is just fine,” right? It’s bad. Everyone recognizes it. It causes huge distortions and problems.

Steve Weisman: And that’s progress, right?

Simon Johnson: It is very big progress to have them say that in public, yes, and for people around the policy discussion to recognize this. There’s obviously still a division of opinion about how to handle the “too big to fail,” and there are various somewhat crazy schemes that are put around. But at least no one can say now “too big to fail” is not a problem, “too big to fail” is not the essence of what we’re struggling with here.

Steve Weisman: Simon, you, in your forthcoming book and in your other pieces, have your own approach on “too big to fail,” so let me allow you to give a plug to your book.

Simon Johnson: Thanks. The book is called 13 Bankers. It deals with the recent financial history of the United States. It’s not a book particularly about the crisis of 2008–2009. The crisis of course is mentioned but it’s a small punctuation mark, a comma, if you like, in this longer run history.

And we actually go back over a longer period—a hundred years and in some points back to it being a republic—to look at where concentrated financial patterns come from in the United States, how it’s been dealt with in previous iterations, and what we’re going to do about this particular version.

Steve Weisman: What do we do now? Break up the major banks—put limits on the size of the economy that they can occupy in effect?

Simon Johnson: Yes, exactly right. We’re arguing among other things—it’s not the single magic bullet, but we think it’s the one major piece missing from the current reform agenda—a hard-sized cap on the size of banks. And actually in the Riegle-Neal Act of 1994, there is a size cap on banks. No bank can be more that 10 percent of total retail deposits. Now, since 1994 the action has not been in retail deposits and, of course, the regulators waived Bank of America through when they were actually going to break through that ceiling a couple of years ago.

What we need to do is go back to that principle, which is not a principle of antimonopoly and traditional antitrust measures, it’s a sensible macroprudential idea of don’t put too many eggs in one basket. And it’s actually a throwback to Teddy Roosevelt who said, “The essence of the problem with concentrated economic power is not particularly just market share and pricing and so on and so forth; it’s political power.”

So, we want a percent of GDP to be the cap. And you can choose within that whether you want to call yourself an investment bank or a commercial bank. And investments banks would have a lower cap because they’re more risky. And we can argue about the specific numbers but once you put the cap on, it’s up to the bank to comply.

Steve Weisman: But why should a bunch of smaller banks working together be less influential than a smaller bunch of bigger banks when they both wield a huge amount of economic power?

Simon Johnson: This is where the notion of the 13 Bankers comes in. And I won’t give away too much of who exactly are the 13 banks, but we do name their names and we do take you through in some—

Steve Weisman: They’re alive still?

Simon Johnson: They are present in several forms in the book, let us say, and they are very concrete, specific people and also institutions. And they are the people at the center of the system. And you know for a long time, Steve, in the 19th century and also in the 20th century, after the reforms of the 1930s, we had a very dispersed financial system relative to almost all other countries.

Actually, concentrated financial power has not been our top problem until the last 20 years.

Steve Weisman: Until recently. And you think this is a better solution than returning to Glass–Steagall as Paul Volcker and some others advocate.

Simon Johnson: Well, I think Paul Volcker is very much a voice to be listened to in this debate. I think he’s right on all the big substance. And in our size cap proposal, we have a different cap
for banks, according to whether they are investment banks—or you can call them casino banks, if you like—or a more boring utility payment system type bank. So that allows banks or forces banks to decide for themselves which kind of bank they are. And if you want to be a more risk-taking bank, then you have a lower size cap.

Steve Weisman: Okay. Simon, let’s talk about the bank tax. You said you like the idea or you have some
problems with it.


Simon Johnson: What I like about it is it’s an acknowledgement by Treasury, by the White House that
we have a problem with the biggest banks. So that the tax is not on all banks, it’s on the biggest financial institutions. Probably it will end up with the top 50. It has to go through Congress; so it will be shaped, or reshaped, as it goes through Congress. But the basic idea is you are—you know, the taxing, or some people are calling it an assessment on the largest
banks that caused a big chunk of the problem.

So, that principle is a good one but the government says, and President Obama said this week,
“We’re going to recoup every penny that we had to spend because of the banks.” And every penny according to the numbers that he and the White House are using this week is $90 billion. That’s a very interesting number, $90 billion. Where do you get the idea that that is the cost of the damage caused by the banks? Perhaps you can argue that’s the direct cost from the TARP.

Steve Weisman: From the TARP, yes.

Simon Johnson: Yes, but Steve—

Steve Weisman: But the larger cost to the economy is the multiples of that, right?

Simon Johnson: First of all, let’s not take the 8 million jobs lost since December 2007, okay? Put that to one side. Let’s just take the fiscal cost, right? So the fiscal cost—and let’s leave out the Federal Reserve part—we’ll take that out of the picture too. Let’s just look at the fiscal cost. We’ve also have a fiscal stimulus, which was necessary because the banks were collapsing.

Steve Weisman: Seven hundred and eighty-seven billion.

Simon Johnson: And we also have the so-called automatic stabilizers, which is the extent to which the
budget goes into deficit as this economy slows down. So that’s extra spending relative to revenues compared to what we would have had.
And actually, what you should look at, Steve, if you want to talk costs—

Steve Weisman: Look at the budget deficit of $1.4 trillion?

Simon Johnson: Well, no, what you should look at is the change in net government debt, relative to the
baseline that the Congressional Budget Office had before the crisis.

Steve Weisman: Okay, so your objection is that this tax is too small.

Simon Johnson: Not exactly, Steve. Now, let me finish. So, I’m saying that if we want to do fiscal cost,
that’s fine. When we do fiscal cost, we’re talking 30 to 40 percent of GDP, okay? Now, you
cannot levy that as an assessment or a tax when you go to call on the banks.

Steve Weisman: On the banking system.

Simon Johnson: They wouldn’t be able to—

Steve Weisman: It would break it.

Simon Johnson: Which tells you that this is not a problem that can be addressed by tax. In fact, economists would tell you that most problems you can either address by regulation or by tax and they
are, to some extent,interchangeable or substitutes, perhaps complements in some cases.

But in this case, the reckless risk taking, the damage that was caused, cannot be fixed by tax because you can’t tax them enough to make a difference, Steve, without banking systems that function. You have to come at this from a regulatory perspective.

Steve Weisman: What about a tax as is being considered in Europe on bank or financial transactions, is that a good idea?

Simon Johnson: Not really. I mean, that would just distort transactions offshore. If you had all of the G-20 together agreeing to do it, you would get some traction, you would generate some
revenue. But the problem, Steve, is not financial transactions; it’s not me and you buying stocks or bonds for our retirement. The problem is massive positions being taken by banks, committing their own balance sheets. And the point is, there’s an upside if they get it, when there’s a downside the taxpayer is responsible and savers lose out because interest rates get cut down to zero and the 8 million jobs that we lost since December 2007. That’s who gets the cost.

Steve Weisman: By the way, didn’t you find it interesting also that the banking executives who testified all expressed gratitude for the government actions that helped them? I mean, they didn’t want to seem ungrateful.

Simon Johnson: That’s because they’ve seemed so ungrateful to this point, Steve. But the expressions of gratitude are neither here nor there. The key issue of the day at the moment is the bonuses.

And not because bonuses necessarily are bad and not because—and I’m not opposed to people getting bonuses for good work. The problem is that the government’s strategy is allowing the banks to recapitalize themselves by making a lot of money—and this was also
used in the early 1980s, by the way, after the Latin American debt crisis—recapitalization of the banks to the retained earnings.
But it only works if you retain the earnings. If you pay them out, either to your shareholders or in this instance to your workers as record bonuses, you’re not rebuilding your capital and you’re not building your capital, you’re not rebuilding your cushion against future losses. So Jamie Dimon—actually, quite extraordinary today, they presented fourthquarter earnings in a conference call. And there’s a lot of sensible caveats in their macro view. They say a lot of things can go wrong and they’re concerned about credit cards, they’re concerned about real estate.

Nevertheless, it looks like their payout of bonuses will be about 30 percent of their gross profits for the year. So, you have to ask—

Steve Weisman: Is that in line with what they have been paid in the past or is that higher this year?

Simon Johnson: They were paid very high bonuses in dollar terms and I think the percentage payout will be lower. Two thousand and nine was a bumper year, Steve, because they got a fantastic deal. They
got the greatest bailout in the history of humankind, and it was the most generous bailout too.

Management gets to keep their jobs. The bonuses structure or compensatory structure, it was not really addressed in all the big banks. And we are heading for trouble again, Steve, because it’s all about incentives. The incentive is to go out and take risks in a reckless manner again.

Steve Weisman: On that note, thanks for joining us, Simon. One advantage of heading for trouble is that there will still be more to talk about with you. Come back.

Simon Johnson: I look forward to it.