Economix Blog: Simon Johnson: The Huntsman Alternative

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The euro zone financial situation continues to worsen. The latest idea from the euro group of finance ministers is apparently to have the European Central Bank make a huge loan to the International Monetary Fund, which would then turn around and lend to countries like Italy. This is a bizarre notion.

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If the monetary fund takes the credit risk of a megaloan to Italy — e.g., an amount around $600 billion, greater than the fund’s current lending capacity — this would represent an unprecedented and unacceptable risk to the fund’s shareholders, which include the American taxpayer. If the monetary fund does not take this credit risk, what’s the point?

The European Central Bank should provide financial support directly to Italy, if that is the goal.

But that goal increasingly seems to be both the only idea of officials and the last failed notion of a fading era. More bailouts and the reinforcement of moral hazard — protecting bankers and other creditors against the downside of their mistakes — is the last thing that the world’s financial system needs.

Yet this is also the main idea of the Obama administration. Treasury Secretary Timothy Geithner told The Fiscal Times this week that European leaders “are going to have to move more quickly to put in place a strong firewall to help protect countries that are undertaking reforms” – meaning more bailouts. And the new swap lines of easier credit provided by the Federal Reserve and other central banks, announced Wednesday, appear to be just another way to shore up European (and perhaps American) banks with no strings attached.

This week we also learned more about the underhanded and undemocratic ways in which the Federal Reserve saved big banks last time around. (You should read Ron Suskind’s book, “Confidence Men: Wall Street, Washington, and the Education of a President.” To understand Mr. Geithner’s philosophy of unconditional bailouts, remember that he was president of the Federal Reserve Bank of New York before becoming Treasury secretary.)

Is there really no alternative to pouring good money after bad?

In a policy statement released this week, Jon Huntsman, the former governor of Utah who is seeking the Republican presidential nomination, articulates a coherent alternative approach to the financial sector, which begins with a diagnosis of our current problem: too-big-to-fail banks:

To protect taxpayers from future bailouts and stabilize America’s economic foundation, Jon Huntsman will end too-big-to-fail. Today we can already begin to see the outlines of the next financial crisis and bailouts. More than three years after the crisis and the accompanying bailouts, the six largest U.S. financial institutions are significantly bigger than they were before the crisis, having been encouraged by regulators to snap up Bear Stearns and other competitors at bargain prices.

Mr. Geithner feared the collapse of big banks in 2008-9, but his policies have made them bigger. This makes no sense.

Every opportunity should be taken to make the megabanks smaller, and plenty of tools are available, including hard size caps and a punitive tax on excessive size and leverage (with any proceeds from this tax used to reduce the tax burden on the nonfinancial sector, which will otherwise be crushed by the big banks’ continued dangerous behavior).

The goal is simple, as Mr. Huntsman said in his recent Wall Street Journal opinion piece: make the banks small enough and simple enough to fail. “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,” he wrote. “There is no reason why banks cannot live with the same reality.”

The path we are on leads to more state ownership of banks in Europe — not a good idea — and, in the United States, huge open-ended subsidies to private banks. Executives in those banks get the upside and American taxpayers and workers get the downside — a huge recession, damage to millions of lives and a huge run-up in government debt because of lost tax revenue.

Everything else Mr. Huntsman wants is also eminently sensible, including full transparency in the derivatives market. Who will argue with that proposal as we watch the European financial sector spiral downwards — driven partly by the fear of what lurks in prominent opaque transactions and balance sheets?

Mr. Huntsman has also spotted the fatal flaw in Basel III: “The Basel III Accord primes the pump for the next financial crisis by putting its thumb on the scale of sovereign debt, making it less expensive for banks to invest in those instruments without making a realistic risk assessment.” Again, in the light of recent developments in Europe, who can dispute this?

These are not fringe or unproven ideas. When I talk with sensible people in and around the financial sector, these are exactly their views. These are also natural Republican ideas — what we have now is not a market but a huge, unfair and dangerous subsidy scheme.

Such points are made by top academics like Gene Fama (University of Chicago) and Alan Meltzer (Carnegie Mellon), by the former Treasury Secretaries Nicholas Brady and George Shultz, and by top Federal Reserve officials, like Richard Fisher (president of the Dallas Fed) and Tom Hoenig (recently retired from being president of the Kansas City Fed and currently nominated for the No. 2 post at the Federal Deposit Insurance Corporation). (See my coverage of this strong current of Republican thinking in past Economix columns.)

Only Theodore Roosevelt could take on the industrial and railroad monopolies in 1901, only Richard Nixon could go to China in 1972, and only Jon Huntsman seems prepared to face down the too-big-to-fail banks today.

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