October 20, 2017

Economix Blog: A Call to Battle on Bank Leverage

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

On Tuesday, federal banking regulators opened an important new phase of the debate on how safe very large financial institutions should become. The next round of argument will be intense; the focus has shifted to the specific and high-stakes question of how much leverage big banks can have – i.e., how much of each dollar on their balance sheet they should be allowed to fund with debt rather than with equity.

Today’s Economist

Perspectives from expert contributors.

The people who run global megabanks would rather fund them with relatively more debt and less equity. Equity absorbs losses, but these very large companies are seen as too big to fail – so they benefit from implicit government guarantees. A higher degree of leverage – meaning more debt and less equity – means more upside for the people who run banks, while the greater downside risks are someone else’s problem (the central bank, the taxpayer or, more broadly, you).

A key regulator on this issue is the Federal Deposit Insurance Corporation, which was created in 1933 to insure banking deposits – and hence serves as a crucial underpinning for public confidence in the financial system. The F.D.I.C. has a responsibility to financial institutions that pay insurance premiums; the goal is to avoid using federal tax dollars, so any losses are absorbed by the insurance fund.

Small banks have been pointing out for some time that while they pay a great deal in insurance premiums, the main dangers in the financial system arise from the excessive leverage and more generally mismanaged risk-taking of big banks. The Independent Community Bankers of America has an excellent set of materials on ending too big to fail, in which it asserts,

The U.S. will not have a robust and truly competitive market for financial services until the too-big-to-fail problem is definitively resolved.


I highly recommend the white paper put out by the association on this issue.

On the F.D.I.C. board, the strongest voices for limiting leverage by big banks have been the two Republican appointees, Thomas Hoenig and Jeremiah Norton. If either were in charge, my guess is that we would end up with a leverage ratio closer to 10 percent than 5 percent. (The way “leverage ratio” is defined in this debate is confusing – a higher ratio actually means more equity is required relative to debt, so a higher ratio implies less debt and a safer system, all other things being equal. As with all discussions of financial transactions, you need to check the fine print.)

Martin J. Gruenberg, the chairman of the F.D.I.C., has also been good on the leverage issue (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Committee, but I’m not involved in any of their work on bank capital or leverage). In its official announcement of the proposed rule-making, the F.D.I.C. said:

A strong capital base at the largest, most systemically significant U.S. banking organizations is particularly important because capital shortfalls at these institutions have the potential to result in significant adverse economic consequences and contribute to systemic distress both domestically and internationally. Higher capital standards for these institutions will place additional private capital at risk before the federal deposit insurance fund and the federal government’s resolution mechanisms would be called upon, and reduce the likelihood of economic disruptions caused by problems at these institutions.

The problem appears to be the board of governors of the Federal Reserve Board, which once again appears to have given in to industry pressure.

The big banks swear up and down that to subject them to a tougher leverage requirement (less debt, more equity for them) would somehow derail the economic recovery or even crater the global economy.

This is a complete fabrication – read the independent bankers’ report or look at the recent paper by Anat Admati and Martin Hellwig, “The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked,” which goes in detail through all the fallacious arguments that have surfaced in response to their recent book, “The Bankers’ New Clothes.”

Plenty of smaller banks are willing and able to lend to companies and individuals in the real (i.e., nonfinancial) economy. The bankers’ association, Mr. Hoenig, Mr. Norton and other current and former officials (such as Sheila Bair, the former head of the F.D.I.C.) want to end the subsidies received by too-big-to-fail banks. Create an even playing field by removing – or at least reducing – the advantages enjoyed by the very largest banks, which benefit not just from an implicit subsidy but can borrow on advantageous terms from the central bank and obtain other privileged forms of official support not available to anyone else.

The Fed’s board, unfortunately, has sided with the megabanks, resisting attempts by the F.D.I.C. to set an interim final rule on leverage (which would be more definite and harder to lobby than the proposal put on the table) and pushing back against the idea that the leverage ratio for megabanks should be at least 6 percent.

So what we have instead is a proposal, which will now receive comments, for the leverage ratio to be 5 percent for the largest eight or so financial companies (at the holding company level; debt levels would need to be slightly lower at insured bank subsidiaries). At the same time, this does present an opportunity. There is a split of opinion within officialdom, and the F.D.I.C. still wants to do the right thing – put a tougher cap on leverage. The comment period can cut both ways; representatives of the big banks will argue for 4 percent or even 3 percent (the minimum under the Basel III capital accord), but those more concerned with financial stability can still push for 10 percent or even higher (i.e., allowing less debt and insisting on more equity).

The F.D.I.C. has made some progress but now needs help. With encouragement from their constituents, Congressional representatives might be persuaded to push for tougher limits on the leverage at big banks.

Article source: http://economix.blogs.nytimes.com/2013/07/11/a-call-to-battle-on-bank-leverage/?partner=rss&emc=rss

Today’s Economist: A Call to Battle on Bank Leverage

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

On Tuesday, federal banking regulators opened an important new phase of the debate on how safe very large financial institutions should become. The next round of argument will be intense; the focus has shifted to the specific and high-stakes question of how much leverage big banks can have – i.e., how much of each dollar on their balance sheet they should be allowed to fund with debt rather than with equity.

Today’s Economist

Perspectives from expert contributors.

The people who run global megabanks would rather fund them with relatively more debt and less equity. Equity absorbs losses, but these very large companies are seen as too big to fail – so they benefit from implicit government guarantees. A higher degree of leverage – meaning more debt and less equity – means more upside for the people who run banks, while the greater downside risks are someone else’s problem (the central bank, the taxpayer or, more broadly, you).

A key regulator on this issue is the Federal Deposit Insurance Corporation, which was created in 1933 to insure banking deposits – and hence serves as a crucial underpinning for public confidence in the financial system. The F.D.I.C. has a responsibility to financial institutions that pay insurance premiums; the goal is to avoid using federal tax dollars, so any losses are absorbed by the insurance fund.

Small banks have been pointing out for some time that while they pay a great deal in insurance premiums, the main dangers in the financial system arise from the excessive leverage and more generally mismanaged risk-taking of big banks. The Independent Community Bankers of America has an excellent set of materials on ending too big to fail, in which it asserts,

The U.S. will not have a robust and truly competitive market for financial services until the too-big-to-fail problem is definitively resolved.


I highly recommend the white paper put out by the association on this issue.

On the F.D.I.C. board, the strongest voices for limiting leverage by big banks have been the two Republican appointees, Thomas Hoenig and Jeremiah Norton. If either were in charge, my guess is that we would end up with a leverage ratio closer to 10 percent than 5 percent. (The way “leverage ratio” is defined in this debate is confusing – a higher ratio actually means more equity is required relative to debt, so a higher ratio implies less debt and a safer system, all other things being equal. As with all discussions of financial transactions, you need to check the fine print.)

Martin J. Gruenberg, the chairman of the F.D.I.C., has also been good on the leverage issue (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Committee, but I’m not involved in any of their work on bank capital or leverage). In its official announcement of the proposed rule-making, the F.D.I.C. said:

A strong capital base at the largest, most systemically significant U.S. banking organizations is particularly important because capital shortfalls at these institutions have the potential to result in significant adverse economic consequences and contribute to systemic distress both domestically and internationally. Higher capital standards for these institutions will place additional private capital at risk before the federal deposit insurance fund and the federal government’s resolution mechanisms would be called upon, and reduce the likelihood of economic disruptions caused by problems at these institutions.

The problem appears to be the board of governors of the Federal Reserve Board, which once again appears to have given in to industry pressure.

The big banks swear up and down that to subject them to a tougher leverage requirement (less debt, more equity for them) would somehow derail the economic recovery or even crater the global economy.

This is a complete fabrication – read the independent bankers’ report or look at the recent paper by Anat Admati and Martin Hellwig, “The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked,” which goes in detail through all the fallacious arguments that have surfaced in response to their recent book, “The Bankers’ New Clothes.”

Plenty of smaller banks are willing and able to lend to companies and individuals in the real (i.e., nonfinancial) economy. The bankers’ association, Mr. Hoenig, Mr. Norton and other current and former officials (such as Sheila Bair, the former head of the F.D.I.C.) want to end the subsidies received by too-big-to-fail banks. Create an even playing field by removing – or at least reducing – the advantages enjoyed by the very largest banks, which benefit not just from an implicit subsidy but can borrow on advantageous terms from the central bank and obtain other privileged forms of official support not available to anyone else.

The Fed’s board, unfortunately, has sided with the megabanks, resisting attempts by the F.D.I.C. to set an interim final rule on leverage (which would be more definite and harder to lobby than the proposal put on the table) and pushing back against the idea that the leverage ratio for megabanks should be at least 6 percent.

So what we have instead is a proposal, which will now receive comments, for the leverage ratio to be 5 percent for the largest eight or so financial companies (at the holding company level; debt levels would need to be slightly lower at insured bank subsidiaries). At the same time, this does present an opportunity. There is a split of opinion within officialdom, and the F.D.I.C. still wants to do the right thing – put a tougher cap on leverage. The comment period can cut both ways; representatives of the big banks will argue for 4 percent or even 3 percent (the minimum under the Basel III capital accord), but those more concerned with financial stability can still push for 10 percent or even higher (i.e., allowing less debt and insisting on more equity).

The F.D.I.C. has made some progress but now needs help. With encouragement from their constituents, Congressional representatives might be persuaded to push for tougher limits on the leverage at big banks.

Article source: http://economix.blogs.nytimes.com/2013/07/11/a-call-to-battle-on-bank-leverage/?partner=rss&emc=rss

Economix Blog: How Immigration Reform Would Help the Economy

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

After many months of rival assertions by interested parties, we finally have an authoritative assessment by an impartial referee of the effects of the so-called Gang of Eight senators’ proposed legislation on immigration. On Tuesday, based on work with the Joint Committee on Taxation, the Congressional Budget Office released two reports – one on the direct federal budget impact and one on the broader and longer-run economic effects, with a helpful summary blog post by the office’s director, Douglas Elmendorf).

Today’s Economist

Perspectives from expert contributors.

The assessment is positive. This precise immigration proposal would improve the budget picture (see this helpful chart) and stimulate economic growth. The immediate effects are good and the more lasting effects even better. If anything, the long-run positive effects are likely to be even larger than the C.B.O. is willing to predict, in my assessment. (I’m a member of the office’s Panel of Economic Advisers but I was not involved in any way in this work.)

The debate over immigration is emotionally charged and, judging from recent blog posts, the Heritage Foundation in particular seems primed to dispute every detail in the C.B.O. approach – and to assert that it is underestimating some costs (including what happens when illegal immigrants receive an amnesty and subsequently claim government-provided benefits, a point Heritage has emphasized in its own report).

There is good reason for the C.B.O.’s careful wording in its analysis; it operates within narrow guidelines set by Congress, and its staff is wise to stick to very well-documented points. Still, as the legislation gains potential traction, it is worth keeping in mind why there could be an even larger upside for the American economy.

In 1776, the population of the United States was around 2.5 million; it is now more than 316 million (you can check the real-time Census Bureau population clock, but of course that is only an estimate).

Think about this: What if the original inhabitants had not allowed immigration or imposed very tight restrictions – for example, insisting that immigrants already have a great deal of education? It’s hard to imagine that the United States would have risen as an economy and as a country. How many United States citizens reading this column would be here today? (I’m proud to be an immigrant and a United States citizen.)

The long-term strength of the United States economy lies in its ability to create jobs. For more than 200 years as a republic (and 400 years in total) immigrants have not crowded together on a fixed amount of existing resources – land (in the early days) or factories (from the early 1800s) or the service sector (where most modern jobs arise). Rather the availability of resources essential for labor productivity has increased sharply. Land is improved, infrastructure is built and companies develop.

Most economic analysis about immigration looks at wages and asks whether natives win or lose when more immigrants show up in particular place or with certain skills. At the low end of wage distribution, there is reason to fear adverse consequences for particular groups because of increased competition for jobs. In fact, the C.B.O. does find that income per capita would decline slightly over the next 10 years before increasing in the subsequent 10 years: “Relative to what would occur under current law, S. 744 would lower per capita G.N.P. by 0.7 percent in 2023 and raise it by 0.2 percent in 2033, according to C.B.O.’s central estimates.”

And it is reasonable to ask who will pay how much into our tax system – and who will receive what kind of benefits. This is the terrain that the C.B.O. and the Heritage Foundation are contesting. (See, too, a letter to Senator Marco Rubio, Republican of Florida, from Stephen Gross, the chief actuary of the Social Security Administration. Mr. Gross said immigration reform would be a net positive; of the current 11.5 illegal immigrants, “many of these individuals already work in the country in the underground economy, not paying taxes, and will begin paying taxes” if the immigration legislation are adopted. New illegal immigration would decline but not be eliminated.)

But the longer-run picture is most obviously quite different. The process of creating businesses and investing – what economists like to call capital formation – is much more dynamic than allowed for in many economic models.

People will save and they will invest. Companies will be created. The crucial question is who will have the ideas that shape the 21st century. (See, for example, the work of Charles I. Jones of Stanford University on this point and a paper he and Paul Romer wrote for a broader audience.)

This is partly about education – and the proposed legislation would tilt new visas more toward skilled workers, particularly those in science, technology, engineering, and math (often referred to as STEM).

But it would be a mistake to limited those admitted – or those allowed legal status and eventual citizenship – to people who already have or are in the process of getting a university-level education. To be clear, under the new system there may well be more low-wage immigrants than high-wage immigrants, but the transition to a point system for allocating green cards is designed to increase the share of people with more education and more scientific education, relative to the situation today and relative to what would otherwise occur.

Many people have good ideas. The Internet has opened up the process of innovation. I don’t know anyone who can predict where the next big technologies will come from. I also don’t know who will figure out how to organize production – including the provision of services – in a more effective manner.

We are competing in a world economy based on human capital, and people’s skills and abilities are the basis for our productivity. What we need more than anything, from an economic point of view, is more people (of any age or background) who want to acquire and apply new skills.

Increasing the size of our domestic market over the last 400 years has served us well. Allowing in immigrants in a fiscally responsible manner makes a great deal of sense — and the reports from the Joint Committee on Taxation and C.B.O. are very clear that this is now what is on the table. If the children of immigrants want to get more education, we should welcome the opportunity that this presents. When you cut off the path to higher education, you are depriving people of opportunity – and you are also hurting the economy.

The deeper political irony, of course, is that if the Heritage Foundation and its allies succeed in defeating immigration legislation, there are strong indications that this will hurt the Republican Party at the polls over the next decade and beyond. Yet, even so, House Republicans seem inclined to oppose immigration reform. That would be a mistake on both economic and political grounds.

We are 316 million people in a world of more than 7 billion – on its way to 10 billion or more (read this United Nations report if you like to worry about the future).

We should reform immigration along the lines currently suggested and increase the supply of skilled labor in the world. This will both improve our economy and, at least potentially, help ensure the world stays more prosperous and more stable.

Article source: http://economix.blogs.nytimes.com/2013/06/20/how-immigration-reform-would-help-the-economy/?partner=rss&emc=rss

Today’s Economist: The Case for Megabanks Fails

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The megabank lobby has finally put its best arguments on the table. After years of silly Twitter posts, weak research papers and other forms of unimpressive public relations, those opposed to further financial reform now have serious representation in the debate about what to do regarding too-big-to-fail banks.

Today’s Economist

Perspectives from expert contributors.

On April 30, the law firm Davis Polk Wardwell issued “Brown-Vitter Bill: Commentary and Analysis,” confronting head-on the proposal from Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana, that would require bigger banks to fund themselves with more equity (and less debt, relative to their total balance sheet).

The Davis Polk document, well written and with clear footnotes to its sources, provides transparency and style, a great improvement over most pro-megabank writing that I have reviewed here over the years. On substance, however, Davis Polk is completely wrong.

We can break down the problems with its analysis into five dimensions of banking: law, economics, markets, politics and history.

On key points of law, the Davis Polk analysis is less than complete. This might seem surprising, given that Davis Polk is one of the country’s best-known law firms, but if it accurately described the full legal situation, all is lost for its case. The heart of the problem is cross-border resolution, in other words, the ability of the Federal Deposit Insurance Corporation to manage the government-supervised approach to handling the failure of a global megabank.

Davis Polk makes a big deal out of Title II of the 2010 Dodd-Frank legislation, which granted new powers to the F.D.I.C. And it is right that under some circumstances it could be helpful to use the proposed “single point of entry” approach by the F.D.I.C. — meaning that this agency would recapitalize a failing financial company solely through liquidating the holding company, wiping out equity and converting debt into equity.

Davis Polk, however, is wrong to imply (see the top of Page 7) that bankruptcy courts could not already handle the precedence of claims; it’s the extension of F.D.I.C. power to bank holding companies and nonbank financial companies that is new here.

But this resolution authority does not apply across borders. It needs to be supplemented by a network of agreements with other countries, which would agree in advance exactly how to handle various assets and liabilities (as the F.D.I.C. is committed to do in the United States). Citigroup, for example, does business in more than 100 countries. So far, the F.D.I.C. has an agreement with the Bank of England, which could be helpful, although it remains to be seen how it holds up in a crisis (and the requisite legislation in Britain is not in place yet). But where is the agreement with the euro zone or Asia or any other market where Citi (or our other largest five banks) have their global presence? There is none, and there is no prospect for such an agreement.

Davis Polk refers to a resolution simulation run by the Clearing House (see the top of Page 8). But this simulation assumed a very simple cross-border structure and also that the British cooperated fully with the American authorities. If you are willing to assume that the world will be such an easy place to work, then why worry about anything? This is not a smart public policy approach.

On economics, Davis Polk cites Anat Admati and Martin Hellwig’s new book, “The Bankers’ New Clothes” (the first time I have seen the megabank side acknowledge that the book exists). Unfortunately, its staff members show no sign of having read it. Professors Admati and Hellwig have already refuted all the points about economics that Davis Polk tries to make.

Davis Polk is very taken with the idea that Professors Admati and Hellwig’s argument rests entirely on theory developed by Franco Modigliani and Merton Miller (and they also mention me as following this approach). Davis Polk then makes a big deal about how this theory does not entirely match the real world.

But nobody asserts that it does match for banks or for any other company. It only provides a starting point for thinking about issues that do matter in the real world.

Professors Modigliani and Miller made an important point — an increase in leverage, by itself (i.e., more debt relative to equity in the funding of a firm) does not create value. Banks, however, love leverage more than other companies because it allows them to exploit guarantees and subsidies from taxpayers.The heart of today’s economic argument is much more about the nature of the subsidies provided to very large financial institutions and how these distort incentives. The people running these companies are encouraged to take on more debt because this allows them to get more of the upside when things go well, while the downside is someone else’s problem.

In effect, global megabanks are creating a very high level of systemic risk, a form of pollution. They should at least pay a fee. That we subsidize and therefore encourage this financial pollution makes no sense. This is all well explained by Professors Admati and Hellwig in Chapter 9 of their book.

Davis Polk is also impressed with some recent working papers that assert that banks play an important role in the economy, including by issuing debt. That may be the case, although you might question how much weight you want to put on working papers and speeches dated April 11 and April 12, 2013 (see Footnotes 17 and 18).

But these arguments are largely irrelevant to the issues at hand — again, see Professors Admati and Hellwig (Chapter 10). The downside risks associated with highly leveraged large banks are many; look around as we stumble out of the deepest and longest recession since the 1930s. By all means, allow big banks to issue debt. The point is to require that it be backed by a lot more equity than is currently the case (i.e., the precise proposal of Brown-Vitter). If these activities are truly valuable, they will continue when the subsidies are curtailed.

On markets, Davis Polk takes the current megabank line that there is no proven too-big-to-fail subsidy. This is a weak and inadvisable position. There is a debate about the precise size of this subsidy, but there are similar debates for any interesting economic variable, including gross domestic product, inflation or unemployment. Davis Polk cites Mary Miller, the Treasury under secretary (Page 10), on the idea that there is no subsidy. John Parsons and I took her positions apart here last week, and unfortunately Davis Polk does not engage with any of the main points we made.

And on the topic of recent working papers (from Sept. 1, 2012), I recommend that Davis Polk read “The Value of Implicit Guarantees” by Zoe Tsesmelidakis and Robert C. Merton, which makes the strong case that too-big-to-fail companies receive cheaper funding during crises.

The general question is simple. Does a global megabank borrow more cheaply because creditors expect, with some positive probability, that they will receive downside insurance from the government or the associated central bank under some circumstances?

Talk to people in the credit markets who do not work for big banks. Talk off the record and behind closed doors (so there are no potential repercussions from the too-bit-to-fail crowd) about how they (the actual and potential creditors) perceive the credit of Citigroup or JPMorgan Chase or Deutsche Bank. Creditors understand clearly the value of implicit protection that still exists.

On politics, Davis Polk insists that the government and the Federal Reserve cannot provide further bailouts or any form of subsidies during a crisis. This is naïve.

Henry Paulson, the former head of Goldman Sachs, is not a man you would have picked as likely to want more government intervention. Yet he appeared, as Treasury secretary, with cap in hand before Congress in September 2008, pleading that some form of enormous bailout for the financial system was needed to avert Armageddon.

You might agree or disagree with that assessment by Mr. Paulson and Ben Bernanke, the chairman of the Federal Reserve, but there is no question that this will long remain a country in which Congress trusts our senior officials to tell it to them straight in a crisis. If the secretary of the Treasury and the chairman of the Federal Reserve say they need new legislation to authorize various forms of government subsidy, then this is substantially what they will get —along with a lot of discretion on how to implement it.

The “no future bailout” promises (and legal commitments) in which Davis Polk sets such store are not credible. Congress cannot prevent any future Congress from acting. This is a fundamental principle of our democracy and, in many instances, it has served us well.

The real issue remains: what are the threats and the real policy alternatives in the next crisis? If Citi is on the brink of failure again (and it has been close to failure three times in recent decades), what would the consequences be for the real economy — both in the United States and around the world?

On history (see Pages 11-13), Davis Polk is weak. There are fewer footnotes and more assertions, including points that are plainly wrong (for instance the bizarre idea that “too much common equity and cash reserves” caused persistent deflation at the end of the 19th century (see the last paragraph on Page 12). The firm’s entire discussion of the 19th century neglects to mention that the United States was on a version of the gold standard (without a central bank) that had very particular implications for the dynamics of banking over the business cycle. The analysis also confuses the academic work of Milton Friedman (who focused on the money supply) with that of Mr. Bernanke (who emphasized the role of credit and bank failures in the Great Depression).

It also appears (see Pages 12-13) to confuse the provision of “lender of last resort” liquidity with equity capital requirements. If you want to make our central bank stronger politically and therefore better able to deal with unexpected liquidity crises, you should be on the side of higher equity capital.

And Davis Polk consistently misses the most important point about small banks, in history and today. These companies ought to compete, to succeed and to fail, based on their own actions, when we have a relatively even playing field in our financial sector. We had this for a long time and it worked well. Small banks are willing and able to step up again, once we remove the excessive subsidies from their too-big-to-fail competitors.

Davis Polk ultimately put its cards on the table on Page 13, suggesting that the Fed’s lender-of-last-resort lending — the ultimate backstop — should be available to “all financial institutions engaged in the socially beneficial function of maturity transformation,” meaning the entire financial system.

The term “moral hazard” does not appear in the Davis Polk document, but that is what this is all about. Davis Polk is advocating a continuation of the present distorted incentives or an expansion of these incentives. The firm declined to comment on my critique of its report.

Powerful people on Wall Street will get the upside when things go well; you and I get stuck with the downside. Why is this a good arrangement for anyone other than a few well-placed executives and their lawyers?

Article source: http://economix.blogs.nytimes.com/2013/05/02/the-case-for-megabanks-fails/?partner=rss&emc=rss

Today’s Economists: Simon Johnson: Introducing the Latin Euro

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Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a director of Salute Capital Management Ltd. Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and former chief economist at the International Monetary Fund.

The verdict is now in. Traditional German values lost and the Latin perspective won. Germany fought hard over many years to include “no bailout” clauses in the Maastricht Treaty (the founding document of the euro currency area) and to limit the rights of the European Central Bank to lend directly to national governments.

Today’s Economist

Perspectives from expert contributors.

But last week, the bank’s governing council – over German objections – authorized the purchase of unlimited quantities of short-term national debts and effectively erased any traditional Germanic restrictions on its operations.

The finding this week by the German Constitutional Court that intra-European financial rescue funds are consistent with German law is just icing on this cake, as far as those who support bailouts are concerned.

With this critical defeat at the E.C.B., Germany is forced to concede two points. First, without the possibility of large-scale central-bank purchases of government debt for countries such as Spain and Italy, the euro area was set to collapse.

And second, that “one nation, one vote” really does rule at the E.C.B.; Germany has around one-quarter of the population of the euro area (81 million of a total of around 333 million), but only 1 vote of 17 on the bank’s governing council – and apparently no veto.

The balance of power and decision-making has shifted toward the troubled periphery of Europe. The “soft money” wing of the euro area is in the ascendancy.

This is not the end of the crisis but rather the next stage. The fact that the European Central Bank is willing to purchase unlimited debt from highly indebted nations should not make anyone jump for joy. The previous rule forbidding this was in place for good reason; the German government did not want investors to feel they could lend freely to any euro-area nation and then be bailed out by Germany.

Now investors know they can be bailed out by Germans, both directly through fiscal transfers and through credit provided by the European Central Bank. How does that affect the incentives of borrowers to be careful?

Prime Minister Mariano Rajoy of Spain has now opened the next front in the intra-European credit struggle. Despite the announcement of E.C.B. support, Mr. Rajoy remains elusive regarding whether he would seek the money.

His main concern is that the E.C.B. is insisting that the International Monetary Fund, along with the European Union commission and perhaps the central bank itself, negotiate an austerity program with any nation that needs funds. Such an austerity program is the “conditionality” that the E.C.B. had to assert would exist in order to justify the large bailouts they are promising.

So the battleground moves from whether the European Central Bank can bail out nations to whether austerity programs should be required for bailouts. The peripheral countries will fight this issue tooth and nail, and they will win.

Unemployment in Spain is now around 24.6 percent; in Greece it is 24.4 percent (with unemployment for those 14 to 24 at 55 percent). Both Portugal and Ireland have made progress with their austerity programs, but they are not growing, and their debts remain very large (gross general government debt is projected by the I.M.F.’s Fiscal Monitor to be 115 percent of gross domestic product next year in Portugal and 118 percent of G.D.P. in Ireland).

The current Italian government is well regarded, but large political battles loom, and it is also burdened with big debts (to reach 124 percent of G.D.P. in 2013).

At the same time, European countries outside the euro – including Britain, Sweden, Poland and Norway – are all seen as faring much better.

The Germans will be increasingly drawn toward one plausible conclusion: perhaps the euro area is simply the wrong system. If tough austerity programs do not wrest nations free from high unemployment and overindebtedness, then how are they to get back on the path to growth?

If a one-time devaluation could help release nations from their troubles rather more quickly, perhaps Germany should instead acknowledge – or insist – that the single currency is a failed exchange-rate regime.

The European Central Bank is now fighting for its survival as an organization. Its president, Mario Draghi, and his colleagues have stretched the rule book in order to open the money spigots to purchase troubled nations’ debts. The leaders of troubled nations will fight hard to get all they can with as few promises in return as possible. Elected officials must do this, or they will lose elections.

Europe has strong institutions, including good property rights and vibrant democracy. An independent central bank was long seen as an important manifestation of such institutions. But powerful interests have shifted toward wanting easy credit above all else. And the more the E.C.B. provides such credit, the more powerful those voices on the periphery will become.

We’ve seen such a dynamic operate time and again around the world. When strong regional governments are fighting for resources against national governments, there is a tendency for regions to accumulate large debts, then demand new bailouts at the national level. These battles often end in runaway inflation, messy defaults or both (think Argentina many times or Russia in the 1990s).

The European Central Bank has handed the euro zone’s peripheral governments a great victory at the expense of those who hoped to keep the euro area a solvent, “hard currency” zone through disciplined public finance.

It may be difficult to imagine that wealthy European nations could follow the tragic path to inflation and defaults seen for so long in Latin America. Yet with each “step forward” in this euro crisis, Europe moves further along that same route.

Article source: http://economix.blogs.nytimes.com/2012/09/13/introducing-the-latin-euro/?partner=rss&emc=rss

Economix Blog: Simon Johnson: Why Are the Big Banks Suddenly Afraid?

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Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Top executives from global megabanks are usually very careful about how they defend both the continued existence, at current scale, of their organizations and the implicit subsidies they receive. They are willing to appear on television shows – and did so earlier this summer, pushing back against Sanford I. Weill, the former chief executive of Citigroup, after he said big banks should be broken up.

Today’s Economist

Perspectives from expert contributors.

Typically, however, since the financial crisis of 2008 the heavyweights of the banking industry have stayed relatively silent on the key issue of whether there should be a hard cap on bank size.

This pattern has shifted in recent weeks, with moves on at least three fronts.

William B. Harrison Jr., the former chairman of JPMorgan Chase, was the first to stick out his neck, with an Op-Ed published in The New York Times. The Financial Services Roundtable has circulated two related e-mails “Myth: Some U.S. banks are too big” and “Myth: Breaking up banks is the only way to deal with ‘Too Big To Fail’” (these links are to versions on the Web site of Partnership for a Secure Financial Future, a group that also includes the Consumer Bankers Association, the Mortgage Bankers Association and the Financial Services Institute).

Now Wayne Abernathy, executive vice president of the American Bankers Association, is weighing in – with a commentary on the American Banker Web site.

These views notwithstanding, mainstream Republican opinion is starting to shift against the megabanks, as former Treasury secretary Nicholas Brady makes clear in a strong opinion piece published in The Financial Times.

Mr. Brady was Treasury secretary under Presidents Ronald Reagan and George H.W. Bush, and to the best of my knowledge, no one has ever accused him of being any kind of leftist.

Yet Mr. Brady’s thinking in his Financial Times commentary is strikingly similar to the reasoning that motivated the Brown-Kaufman amendment (supported by 30 Democrats and three Republicans) in 2010, which would have put a hard cap on the size and leverage of our largest banks, i.e., how much an individual institution could borrow relative to the size of the economy. (See this analysis by Jeff Connaughton, who was chief of staff to Senator Ted Kaufman; Senator Sherrod Brown, Democrat of Ohio, is still pushing hard on this same approach.)

Mr. Brady also stresses that we should make our regulations simpler, not more complex. Senator Kaufman made the same point repeatedly – and capping leverage per bank (Mr. Brady’s preferred approach) would be one way to do this.

Mr. Brady is not alone on the Republican side of the political spectrum. A growing number of serious-minded politicians are starting to support the point made by Jon Huntsman, the former governor of Utah and a Republican presidential candidate in the recent primaries: global megabanks have become government-sponsored enterprises; their scale does not result from any kind of market process, but is rather the result of a vast state subsidy scheme.

As Paul Singer, a hedge fund manager and influential Republican donor, says of the big banks, “Private reward and public risk is not what conservatives should want.”

A second problem for the bankers is that their arguments defending big banks are very weak.

As I made clear in a point-by-point rebuttal of Mr. Harrison’s Op-Ed commentary, his defense of the big banks is not based on any evidence. He primarily makes assertions about economies of scale in banking, but no one can find such efficiency enhancements for banks with more than $100 billion in total assets – and our largest banks have balance sheets, properly measured, that approach $4 trillion.

Similarly, the Financial Services Roundtable e-mail on “Some U.S. banks are too big” is based on a non sequitur. It points out that United States trade has grown significantly since 1992, and it infers that, as a result, the size of our largest banks should also grow.

But the dynamism of the American economy and its international trade after World War II was not accompanied by striking increases in the size of individual banks, and our largest banks did not then increase relative to the size of the economy, in sharp contrast to what happened since the early 1990s.

In 1995, the largest six banks in the United States had combined assets of around 15 percent of gross domestic product; they are now over 60 percent of G.D.P., bigger than they were before the crisis of 2008.

The Financial Services Roundtable is right to point out that banks in some other Group of 7 countries are larger relative to those economies. But which of these countries would you really like to emulate today: France, Italy or Britain?

The Financial Services Roundtable also asserts, in its other e-mail, that the Dodd-Frank financial reform legislation and the Basel III new capital requirements have made the banking system safer. That may be true, although the evidence it presents is just about cyclical adjustment; after any big financial crisis, banks are careful about funding themselves with more equity (a synonym for capital in this context) and holding more liquid assets.

The structure of incentives in the industry hardly seems to have changed, as witnessed, for example, by the excessive risk-taking and consequent large trading losses at JPMorgan Chase recently.

We need a system with multiple fail-safes, and making the largest banks smaller and less leveraged would achieve precisely that goal.

Mr. Abernathy’s article takes a much more extreme position. He contends that banks are already unduly constrained – by Dodd-Frank and Basel III – and this is holding back economic growth.

Mr. Abernathy goes so far as to say that if the banks were to raise $60 billion in additional equity capital, this “holds back $600 billion of economic activity.” In other words, strengthening the equity funding of banking would cause an economic contraction on the order of 4 percent of G.D.P.

Such assertions are far-fetched, not based on any facts and have been completely discredited (see the work of Anat Admati and her colleagues on exactly this point). Mr. Abernathy was assistant secretary for financial institutions under George W. Bush. If he has any evidence to support his positions – a study, a working paper, a book? – he should put it on the table now.

To make such assertions without substantiation is irresponsible. (A document from a lobbying organization would not count for much, in my view, but let’s see if he has even that.)

The big banks and their friends should be afraid. Serious people on the right and on the left are reassessing if we really need our largest banks to be so large and so highly leveraged (i.e., with so much debt relative to their equity). The arguments in favor of keeping the global megabanks and allowing them to grow are very weak or nonexistent. The arguments in favor of further strengthening the equity funding for banks grow stronger – see the recent letter by Senators Sherrod Brown and David Vitter, which I wrote about recently.

The views of sensible people like Secretary Brady, Senator Kaufman, Governor Huntsman and Senator Brown are spreading across the political spectrum.

Article source: http://economix.blogs.nytimes.com/2012/08/30/why-are-the-big-banks-suddenly-afraid/?partner=rss&emc=rss

Today’s Economist: Simon Johnson: The End of the Euro Is Not About Austerity

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Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Most current policy discussion concerning the euro area is about austerity. Some people, particularly in German government circles, are pushing for tighter fiscal policies in troubled countries (i.e., higher taxes and lower government spending). Others, including in the new French government, are more inclined to push for a more expansive fiscal policy where possible and to resist fiscal contraction elsewhere.

Today’s Economist

Perspectives from expert contributors.

The recently concluded Group of 20 summit meeting is being interpreted as shifting the balance away from the “austerity now” group, at least to some extent. But both sides of this debate are missing the important issue. As a result, the euro area continues its slide toward deeper crisis and likely eventual disruptive breakup.

The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised never to change that exchange rate. This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the “periphery”) would, in effect, become more like the Germans.

Alternatively, if the economies did not converge, the implicit presumption was that people would move; Greek workers would go to Germany and converge to German productivity levels by working in factories and offices there.

It’s hard to say which version of convergence was less realistic.

In fact, the opposite happened. The gap between German and Greek (and other peripheral country) productivity increased, rather than decreased, over the last decade. Germany, as a result, developed a large surplus on its current account – meaning that it exports more than it imports.

The other countries, including Greece, Spain, Portugal and Ireland, had large current account deficits; they were buying more from the world than they were selling. These deficits were financed by capital inflows (including some from Germany but also through and from other countries).

In theory, these capital inflows could have helped peripheral Europe invest, become more productive and “catch up” with Germany. In practice, the capital inflows, in the form of borrowing, created the pathologies that now roil European markets.

In Greece, successive governments overspent – financed by borrowing — as they sought to stay popular and win elections. Whether the new government installed on Wednesday after last weekend’s elections will make any progress is not clear.

Greece has already adopted a considerable degree of fiscal austerity. Now it needs to find its way to growth. Cutting the budget further won’t do that. “Structural reform” – a favorite phrase of the Group of 20 crowd – takes a very long time to be effective, particularly to the extent that it involves firing people in the short run. Throwing more “infrastructure” loans from Europe into the mix – for example, through the European Investment Bank – is unlikely to make much difference. Additional loans of this kind are likely to end up being wasted or stolen as more and more well-connected people prepare for the moment when the euro is replaced in Greece by some form of drachma.

In Spain and Ireland, capital inflows – through borrowing by prominent banks – pumped up the housing market. The bursting of that bubble has shrunk their real economies and brought down all the banks that gambled on loans to real estate developers and construction companies. Their problems have little to do with fiscal policy.

As conventionally measured, both Ireland and Spain had responsible fiscal policies during the boom, but they were building up big contingent liabilities, in the form of irresponsible banking practices.

When the banks blew up in Ireland, this created a fiscal calamity for the government, mostly because of lost tax revenue. It remains to be seen if Ireland can now find its way back to growth.

Spain still needs to recapitalize its banks – putting more equity in to replace what has been wiped out by losses — and, most important, it must also find a renewed path to private-sector growth. Investors are rightly doubtful that the current policies are pointed in this direction.

In Portugal and Italy, the problem is a longstanding lack of growth. As financial markets become skeptical of European sovereign debt, these countries need to show that they can begin to grow steadily – and bring down their debt relative to gross domestic product (something that has not happened for the last decade or so).

Fiscal austerity will not help, but fiscal expansion is also unlikely to do much – although presumably it could increase headline numbers for a quarter or two. The private sector needs to grow, preferably through exporting and through competing more effectively against imports.

Peripheral Europe could, in principle, experience an “internal devaluation,” in which nominal wages and prices fall and those countries become hyper-competitive relative to Germany and other trading partners. As a matter of practical economic outcomes, it is hard to imagine anything less likely.

Some politicians still hint they could produce the rabbit of “full European integration” from the proverbial magic hat. What does this imply about quasi-permanent transfers from Germany to Greece (and others)? Who pays to clean up the banks? What happens to all the government debt already outstanding? And does this mean that all Europe would now adopt German-style fiscal policy?

These schemes are moving even beyond the far-fetched notions that brought us the euro. “Europe only integrates in the face of crisis” is the last slogan of the euro  enthusiasts. Perhaps, but crises have a tendency to get out of control – particularly when they produce political backlash.

Most likely, the European Central Bank will provide some big additional “liquidity” loans to bring down government bond yields as we head into the summer. We should worry about how long any such feel-good policies last. Historically, August is a good month for a big European crisis.

As these difficult times approach, some people will admonish governments to stand up to markets. But when you are relying on capital markets to finance a large part of your continuing budget deficit and your debt rollover, this is empty bravado.

European governments should never have put their heads so far into the lion’s mouth with regard to public-sector borrowing. But the politicians, and many others, convinced themselves that they were all going to become more like Germany.

Peripheral Europe will never be like Germany. It’s time to face the implications of that fact.

Article source: http://economix.blogs.nytimes.com/2012/06/21/the-end-of-the-euro-is-not-about-austerity/?partner=rss&emc=rss