Monday, October 4, 2010

Simon Johnson and The Next Financial Meltdown

I went to a Boston Security Analysts luncheon today to hear Professor Simon Johnson of MIT.

Mr. Johnson is a widely published and quoted author, with articles in many leading magazines. I first came across his work a couple of years ago through an article that he wrote for the Atlantic magazine, where he compared the problems in the U.S. to those he confronted through his earlier work as an economist for the IMF.

Professor Johnson is the co-author, with James Kwak, of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown, a bestselling assessment of the dangers now posed by the US financial sector.

It was a thought-provoking talk, filled with insights has gleaned not only through his work but also his global contacts. Johnson has testified numerous times in front of Congressional subcommittees with regards to our banking system, and how we should address the various issues confronting us.

He started his talk with three points:
  • Despite the widely-held belief that the financial crisis is over, he does not believe that it is. All of the factors that lead the problems in 2008 and 2009 are still in place;
  • He also does not agree that the most recent financial sector regulation (the Dodd-Frank bill) fixed any of the issues.
  • "Too big to fail" is not the issue - "too big to save" is the problem.
This last point was one that Johnson spent considerable amount of time on.

At some point, he said, countries cannot afford to simply bail out huge banks that get themselves in trouble. He pointed to Ireland, which is taking on a huge fiscal burden and imposing tough austerity measures on its population to bail out the country's three banks. The same is true in England, where the Royal Bank of Scotland is costing taxpayers large sums.

The official view in Washington, according to Johnson, is that what happened in 2008 was a "perfect storm" (a term that he hates, as do I) of bad economic events. Now, he said, government officials believe that the storm has passed, and that Dodd-Frank (creating new financial regulation) will make sure that such events will no longer be able to happen.

A minority view (which happens to be his) is that we spent the last 40 years "tweaking" the banking system to allow banks to take on more risk and increased leverage. The events of 2008, then, were not just the result of the economy being unlucky, but rather events that were the result of failed policies of the prior years.

And what, asked Johnson, was the result of these failures?

The title of his book explains it: 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.

Johnson notes that the leaders of the 13 largest banks in the United States were summoned to Washington in the fall of 2008 and bailed out completely for their actions. No CEO jobs were lost, no pension benefits denied, no board memberships suspended - the U.S. government (and the taxpayers) allowed each of the leaders of the large banks to walk away from the consequences of their actions.

Contrast this favorable treatment with the way that the head of General Motors, Rick Wagoner, was treated after the government took the bankrupt automaker over. While all seemed to agree that he was a capable leader, someone had to take the fall, and as CEO of a company that the government was bailing out he had to go.

So where are we now? All the same leaders are in place, and all have plans to grow even larger. Today the top six banks in the U.S. control almost two-thirds of the assets of the country; 20 years ago, this percentage was just 16%.

In the last 30 years, Citigroup has failed three times. First, in 1982, as the result of bad loans made to Latin and South American countries. Second, in 1989-90, as the result of poor commercial lending. And, third, in 2008 as the result of bad residential mortgage decisions. And yet the same management practices are allowed to go on, with largely the same board.

Professor Johnson said that this not an anti-business view that he holds. Instead, he is very much pro-business. However, he said that it is simply unhealthy that a few large financial institutions hold so much power and influence that all agree - including Johnson - that they would be bailed out again in the next crisis.

One final point: there have been a number of articles noting that TARP wound up costing much less than feared. To Johnson, this view misses the point. True, the dollars directly relating to the bank bailout were less, but the U.S. fiscal debt burden has soared from 40% of GDP to 80%, with no real economic benefit to anyone. Unemployment remains high, GDP for 2010 will probably be equal to 2006, and the outlook that most have for the future is for very sluggish growth.

Johnson compared the big banks today to Big Oil in 1902. Then, Theodore Roosevelt felt that Standard Oil was too big, and could endanger the health of the US economy. The business leaders at the time argued with him, but eventually he prevailed, to the benefit of society.

Now is the time, said Johnson, for business leaders today to take similar action, and try to take the steps to prevent the next crisis. He pointed out that it can take a long time for a crisis to develop; in the early 1920's, for example, the U.S. experienced a boom period, and the stock market moved sharply higher over the next few years. However, by 1929 the system was untenable, and a decade of economic misery followed by a world war resulted. He feels that if we act now we can prevent such another series of calamities.