Simon Johnson

Simon Johnson Explains The Case For Megabanks Fails

2013-05-02T11:04:08-04:00

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.

Sir John Peace Should Resign As Chairman of Standard Chartered Bank

2013-03-21T23:51:57-04:00

On Thursday, March 21, Sir John Peace conceded that he lied to investors on March 5, 2013 when he said of Standard Chartered Bank,

"We had no willful act to avoid sanctions; you know, mistakes are made - clerical errors - and we talked about last year a number of transactions which clearly were clerical errors or mistakes that were made..."

Specifically, he now says that these remarks were "both legally and factually incorrect" because Standard Chartered had previously conceded that it deliberately laundered money.

In plain English, what Sir John said is called lying. Or, if you prefer the language of securities lawyers, he engaged in deliberate misrepresentation. He also violated Standard Chartered's deferred prosecution agreement with US authorities.

Here is the full statement today.

Sir John should resign immediately as chairman of Standard Chartered.

Look carefully at the dates. He lied to investors on March 5 but did not issue this correction until March 21 - apparently after US regulators threatened the bank with renewed prosecution.

If the March 5 remarks were a genuine mistake, Sir John could have retracted them the same day. March 6, 7, and 8 were also pretty much wide open for retractions.

Standard Chartered - in the person of Sir John - has deceived prosecutors, regulators, and the investing public. This is outrageous executive behavior and it cannot be tolerated in a company that holds a US banking license.

If Sir John does not resign, he should be removed by the board of Standard Chartered.

If the bank's board refuses to act, this will signal that it is not competent to oversee the operations of a global bank.

Senator Elizabeth Warren asked recently: before you lose your banking license,

"How many billions of dollars do you have to launder for drug lords?"

Fed Governor Jerome Powell replied (with the wording from the same Politico article),

"I'll tell you exactly when it's appropriate" to consider pulling a bank's license, he said. "It's appropriate when there's a criminal conviction."

Standard Chartered Bank signed a deferred prosecution agreement which, among other things, requires it to take responsibility for its previously illegal sanction-busting actions.

If the chairman publicly and deliberately denies responsibility - in explicit violation of this agreement - he should step down or be forced out. How can the authorities now have any reasonable confidence that Standard Chartered will comply with the rest of its agreement, including,

"Under the cease and desist order, Standard Chartered must improve its program for compliance with U.S. economic sanctions, Bank Secrecy Act, and anti-money-laundering requirements."

If Sir John does not go, Mr. Powell and his colleagues should pull the bank's license.

If under such circumstances the Board of Governors of the Federal Reserve finds it cannot take action, then we must consider amending the Federal Reserve Act.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario. Read more from the Fiscal Affairs series here.

"Some of These Institutions Have Become Too Large"

2013-03-07T08:42:03-05:00

In a recent interview with PBS's Frontline, Lanny Breuer, head of the criminal division at the Department of Justice, appeared to admit that some financial institutions were too big to prosecute. In the "too big to fail is too big to jail" controversy that ensued, lobbyists and other supporters of big Wall Street firms tried all kinds of complicated ways to spin Mr. Breuer's words.

Their job got a lot harder yesterday when Eric Holder, the attorney general, stated clearly to the Senate Judiciary Committee:

"I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy," (Watch the video for yourself.)

According to Mr. Holder, speaking as the top enforcer of the country's laws, "some of these institutions have become too large."

Senator Sherrod Brown (D, OH), a leading voice for making the biggest banks smaller, reacted in this way:

"You expect trouble bringing a criminal to justice when he flees to a hostile foreign country; but it's shocking that the Justice Department cannot pursue criminal activity when somebody simply walks through the doors of a Wall Street megabank. The laws of the United States must apply equally to both a $2-trillion Wall Street bank and a $200-million bank in Ohio."

American Banker, a trade publication, called Mr. Holder's statement a "stunning admission" and suggested this could mark a turning point in the debate about the size of very large financial institutions.

Senator David Vitter (R, LA), who is working with Senator Brown on legislation to reduce the size of our largest banks, said, "It's another glaring example that 'too big to fail' is alive and well" (this is in the American Banker piece). (Any Brown-Vitter legislation would presumably be similar in content to the Brown-Kaufman amendment, which was defeated during the Dodd-Frank Senate debate in spring 2010; you can review Senator Brown's latest legislative proposal here.)

Senator Elizabeth Warren (D, MA) has been outspoken in her opposition to banks that are "too big for trial." Despite being new to the Senate, she has already hammered the regulators on this point. Following Eric Holder's statement she said, "Attorney General Holder's testimony that the biggest banks are too-big-to-jail shows once again that it is past time to end too-big-to-fail."

Some defenders of the global megabanks claim the issues are very complicated and much more study is needed before we take any action. The Board of Governors of the Federal Reserve, for example, seems inclined to do nothing.

This would be a mistake. Eric Holder's remarks yesterday were not accidental or an aside -- he is emphasizing that the world's biggest banks are now above the law. The Dodd-Frank financial reform legislation did not end the problems of "too big to fail".

Will President Obama and his team now do anything about it -- such as supporting the Brown-Vitter legislation or helping Elizabeth Warren put more effective pressure on the Federal Reserve to take immediate action?

Will the Department of Justice itself answer the tough questions posed by Senator Brown and Senator Chuck Grassley after the Lanny Breuer disclosures? Who exactly at the Department of Justice decides that a bank is too big to prosecute - and on what basis? Is there a rule book or a list of criteria? Or, more likely, is this something totally made up on the spur of the moment and on an ad hoc basis?

The Justice Department's budget documents prominently quote Thomas Jefferson: "The most sacred of the duties of government [is] to do equal and impartial justice to all its citizens."

The attorney general just told Congress and the country that this principle no longer applies to very large financial institution.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario. Read more from the Fiscal Affairs series here.

Scott Brown: ATM for the Big Banks

2012-09-30T10:02:38-04:00

During the Dodd-Frank financial reform debate in early 2010, newly elected Senator Scott Brown of Massachusetts was referred to as an ATM for the bankers -- meaning that whenever they needed some more cash, they would stop by his office. It was not paper money he was handing out, of course, it was something much more valuable -- rule changes that conferred a greater ability to take on reckless risk, damage consumers, and impose higher future costs on the taxpayer.

Mr. Brown had this ability because he represented the final vote needed to pass Dodd-Frank through the Senate. He could have asked for many things -- including greater consumer protection, a more thorough investigation into mortgage practices, and reforms that would have cleaned up unscrupulous lenders. He asked for none of those changes -- or anything else that would have made the financial system safer and fairer.

Instead, Senator Brown's requests were designed to undermine the Volcker Rule -- i.e., he was opposing sensible attempts to limit the ability of big banks to place highly dangerous bets (and to blow themselves up at great cost to the rest of us). Mr. Brown seems to have been particularly keen to allow big banks to invest in hedge funds of various kinds -- and the Boston Globe reported recently that he has continued to push in this direction behind the scenes.

Such risky investments earn high returns when times are good (and big bonuses for senior executives), but they also imply large losses when something goes wrong. The special interests involved naturally like, "heads I win, tails you lose," but this is absolutely not in the broader social interest. Banks with FDIC-insured deposits absolutely should not be allowed to engage in such speculative activities. This was the original insight of former Fed Chairman Paul Volcker -- and it remains the right view today.

The economy absolutely does not need banks that can go crazy on various kinds of "proprietary" trading. In fact, it is exactly this kind of mismanagement of risk that brought the financial system to its knees and inflicted great damage on the economy in 2008-09.

Very large financial institutions get implicit government support and effective taxpayer subsidies -- this is what it means to be "too big to fail." This point is widely agreed on the right and the left of the political spectrum. One sensible idea is to offset these subsidies with a levy on large financial institutions, for example based on how much leverage they have -- as large amounts of debt relative to equity is precisely what makes these firms so prone to failure. And there was a "bank levy" of exactly this kind in the Dodd-Frank legislation until the very end. Then Senator Scott Brown killed it -- again, a form of cash withdrawal for the banks (and big future liability for everyone else).

Senator Brown knows the financial sector well -- in fact, he recently acknowledged working specifically on real estate transactions during the boom years. His lobbying of the U.S. Treasury and other government agencies has been sophisticated and exactly in line with the positions of the most dangerous big banks. He has drawn a great deal of support from financial sector donors, both to his campaign and running ads in parallel with his efforts (including through Karl Rove's Crossroads groups.)

In his bid for re-election, Mr. Brown presents himself as some sort of Massachusetts moderate, looking out for our common interest. But his record is unambiguously someone who sticks up for the special interests of big banks -- and creates great risk to the rest of us.

Mr. Brown had a chance to make a difference and he did, ensuring more cash now for big banks and more danger and destruction for the economy later.

Mr. Brown knows the banking sector well and his staff includes sophisticated financial services professionals. They understand exactly what they want and why they want it.

Fortunately, Massachusetts has a choice. The voters can either choose Scott Brown and his allies, the big banks. Or they can choose Elizabeth Warren who has worked hard to make the financial system safer, fairer, and less prone to collapse.

Mr. Brown fooled Massachusetts voters once, in his original election. Who thought they were electing someone to stick up for the global megabanks?

Will he fool them a second time -- when his achievements in diluting sensible financial reform are apparent for all to see?

Vote for Scott Brown if you want to hand the megabanks a mandate to ruin the economy, again.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario. Read more from the Fiscal Affairs series here.

One Man Against The Wall Street Lobby

2012-08-25T18:15:10-04:00

Two diametrically opposed views of Wall Street and the dangers posed by global megabanks came more clearly into focus last week. On the one hand, William B. Harrison, Jr. -- former chairman of JP Morgan Chase -- argued in the New York Times that today's massive banks are an essential part of a well-functioning market economy, and not at all helped by implicit government subsidies.

On the other hand, there is a new powerful voice who knows how big banks really work and who is willing to tell the truth in great and convincing detail. Jeff Connaughton -- a former senior political adviser who has worked both for and against powerful Wall Street interests over the years -- has just published a page-turning memoir that is also a damning critique of how Wall Street operates, the political capture of Washington, and our collective failure to reform finance in the past four years. The Payoff: Why Wall Street Always Wins, is the perfect antidote to disinformation put about by global megabanks and their friends.

Specifically, Mr. Harrison makes six related arguments regarding why we should not break up our largest banks. Each of these is clearly and directly refuted by Mr. Connaughton's experience and the evidence he presents.

First, Mr. Harrison claims that megabanks are the natural outgrowth of requests from customers, rather than the result of extraordinary resources spent on lobbying over the past 30 years. Mr. Connaughton's book contains all you need to know -- and more than you can stomach -- about the realities of how the influence industry has worked diligently to build and defend megabanks. The people who really wanted the banks to become bigger were the executives in charge of those organizations -- like Mr. Harrison. They spent a lot of money to make this happen.

Second, Mr. Harrison takes the view that global megabanks at their current scale provide some special services that cannot be otherwise provided by smaller financial institutions.

As Mr. Connaughton points out -- including in a new blog post -- there are no economies of scale or scope in banks with over $100 billion of total assets. Our largest banks, properly measured, now have balance sheets between $2 trillion and $4 trillion. Plenty of people have attempted to show megabanks produce some magic for broader economy-wide productivity or multinational nonfinancial firms, but there is simply no evidence. Again, read Mr. Connaughton's book for more detail -- or look at my book with James Kwak on this topic, "13 Bankers".

Third, Mr. Harrison claims "large global institutions have often proved more resilient than others because their diversified business model ensures that losses in one part of the enterprise can be cushioned by revenues in other parts."

Mr. Connaughton's book reminds us, with some eloquence, that Citigroup and Bank of America -- the largest U.S. financial institutions in 2008 -- would have failed if it were not for the government bailouts that they received. As a matter of simple historical fact, the "more resilient" in Mr. Harrison's version of history is exactly the same as observing that those banks were seen by officials as "too big to fail." Their resilience came solely from support provided by the government and the Federal Reserve.

Fourth, Mr. Harrison denies that very large banks receive any implicit government subsidies. To support this view, Mr. Harrison suggests we should compare borrowing costs across financial and nonfinancial firms that share a similar bond rating (e.g., AA); he points out that the interest rate paid by financial firms in this comparison is higher. But the interest rate at which a company borrows depends not just on the risk of default, but also on the "recovery value" in the case of default (i.e., how much do creditors end up with after the company has been wound down). If you think you will recover less when I default, you should charge me a higher risk premium -- and thus a higher interest rate.

Mr. Harrison compares apples (finance) with oranges (nonfinance) -- and fails to mention that the recovery rate in the latter case is much higher. How much will investors recover in the case of Lehman, for example -- perhaps 25 cents after more than four years? For most nonfinancial companies, default does not by itself result in a big reduction in value (the deadweight costs for bankruptcy of such firms in the US are quite small); large financial firms are quite different (the deadweight bankruptcy costs are typically huge). Mr. Harrison's proposed comparison is simply uninformative -- you need to look at comparisons within the financial sector.

The right comparison is the funding cost of financial firms with and without implicit government support. The funding advantage for those perceived as Too Big To Fail is estimated to be between 25 and 75 basis points; most people close to the issue think it is at least 50 basis points. The idea that megabanks do not get huge, implicit subsides is simply priceless -- again, read Mr. Connaughton's account to see the lengths to which the banks will go to ensure these subsidies are kept in place.

Fifth, Mr. Harrison says that "complexity can be an antidote to risk, rather than a cause of it". On the contrary, the evidence suggests that management has consistently lost control over financial institutions with hundreds of thousands of employees in 50-100 countries. Think about the scandals of this summer: Barclays and Libor; HSBC or Standard Chartered and money laundering; and the severe breakdown of risk management at JP Morgan Chase. In each case, executives claim they did not know what was going on. The very largest banks have become too big to manage.

Sixth, Mr. Harrison claims regulators are not cowed by banks. The Payoff is all about how lobbying really works -- and how legislators and regulators are brought to heel. Money brings influence and influence is used to make more money. It is not about "cowing" anyone; it is about persuading them that you are right and should be allowed to do exactly what you want to do, even though your arguments are completely specious. Mr. Harrison's op ed is a nice example of the genre.

Some regulators have started to stand up to big banks on some issues, and this should be encouraged. But overall, Wall Street prevails on all the major issues, and most top officials at Treasury and the Federal Reserve are only too happy to cooperate.

Mr. Harrison makes strong claims. All of his arguments are demonstrably false. If you think Mr. Harrison and the other defenders of megabanks have even the slightest veneer of plausibility, you must read Jeff Connaughton's book.

Simon Johnson: Banks' Living Wills Aren't Cure For Systemic Risk

2012-07-09T12:15:33-04:00

Bloomberg View

On July 3, the Federal Deposit Insurance Corp. and the Federal Reserve made public portions of the “living wills” developed recently by major U.S. financial institutions. The documents are the first suggestions from those organizations of what they believe should happen when insolvency looms.

The living wills were prepared in compliance with the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and are a major step forward in terms of revealing how global megabanks are structured. Yet they are shockingly incomplete and flawed in one crucial aspect: They neglect to explain how cross- border assets and liabilities would be handled in different legal jurisdictions.

The plans should be rejected by officials and sent back to the banks to be revised. As these proposals now stand, they are a blueprint for further financial disaster, and additional taxpayer-backed bailouts. (Note: the published parts of these wills haven’t been edited or reviewed by the FDIC or the Fed.)

To the more cynically minded, ignoring cross-border issues is akin to planting a poison pill in the heart of these living wills. When the time comes to wind down a failing megabank, the complexities and potentially dangerous domino effects surrounding the failure of a cross-border institution are likely to increase pressure for a bailout that will protect creditors, and perhaps shareholders and executives, too.

Wall Street’s Captive Arbitrators Strike Again

Flawed Incentives

This is exactly the wrong incentive structure for these banks; it will encourage reckless risk-taking and compensation programs that give management the upside in good times and, when things go badly, the downside losses are pushed onto society.

The legislative and regulatory intent behind living wills is straightforward and sensible. The biggest financial institutions operating in the U.S. are being pressed to help officials understand how best to handle a potential failure without bringing down the financial system.

After the 2008 demise of Lehman Brothers Holdings Inc. the thinking is that saying “just go bankrupt” to a large international bank could cause a great deal of damage across financial markets and around the world. Bankruptcy procedures aren’t well suited to some parts of financial services where there is a great loss of value when funding is no longer available. Creditors are likely to recover no more than 25 cents on the dollar from Lehman, when all is said and done.

But the biggest costs were incurred when the fall of Lehman created fear and disrupted markets more broadly, leading directly to the deepest recession since the 1930s.

If the bankruptcy of a large institution would result in broad financial instability, the FDIC is charged with figuring out how to implement Title II of Dodd-Frank to handle the company’s failure. This new authority is an alternative resolution mechanism that would allow officials to liquidate large financial institutions in an orderly manner. The FDIC’s responsibility turns out to be an extremely complicated and difficult task, precisely because the largest modern banks are so big, and are structured in Byzantine fashion. All the more reason these living wills ultimately need to be credible. (I serve on the FDIC’s Systemic Resolution Advisory Committee, but that panel’s role is only to provide feedback in a public forum.)

The plans available so far are from five of the six largest U.S. financial institutions: JPMorgan Chase & Co. (JPM), Bank of America Corp., Citigroup Inc. (C), Goldman Sachs Group Inc. (GS) and Morgan Stanley. (MS) Wells Fargo & Co. hasn’t submitted a will, which is interesting given that the bank is spending a fortune on lobbying and is definitely in the “too-big-to-fail” category (as the country’s fourth-largest institution by assets).

BREAKING: Barclays Revealed Libor Scandal Four Years Ago

Holding Companies

Each of the U.S. filers has at least two living wills, one for the holding company and one for the bank; Bank of America has a third for its card services. Some of the largest European banks operating in the U.S. are also represented: Barclays Plc (BCS), Deutsche Bank AG (DB), Credit Suisse Group AG (CS) and UBS AG (UBSN); other international players have yet to show their hand (I’m very interested in what the French have to say).

There is useful information here -- particularly in the way that some banks emphasize that parts of operations could be valuable when broken off and sold (JPMorgan makes this point). Executives of these megabanks sometimes suggest that their businesses could only exist in the behemoth size, though that isn’t the implication of these living wills.

The important consideration, however, is how assets and liabilities would be handled when there are cross-border operations and markets, or when officials start to fear that a collapse may be imminent. What assets can be moved and under what conditions? What can be seized by responsible legal authorities in various countries?
And how will client money be protected in this situation? As seen in the MF Global Holdings Ltd. (MFGLQ) case, the treatment of customers and other claimants in London and in New York can be very different.

These international banks like to book their business in various jurisdictions, driven by tax or accounting convenience or regulatory requirements (in the sense of getting around such requirements). The result is a tangle of obligations within the “banks,” that is across the various legal entities that are owned by the holding company, some of which are banks and some of which aren’t.

Ideally, these banks should be organized as separate legal entities, each with its own capital -- and each able to fail “on its own,” without bringing down the rest of the business. There should be no cross-guarantees or other hidden ways of sharing assets and liabilities.

To the extent that any financial institution operates across borders, it should have to justify the social benefit, and explain precisely and in a public manner how this cross- border activity is structured to avoid a systemic risk.

The living-will exercise should be an opportunity for officials to force the global megabanks to simplify along national lines and to build up their equity capital. Unfortunately, while some officials are inclined to push in that direction, other powerful figures -- including at the U.S. Treasury Department and within the Federal Reserve System -- are surprisingly complacent regarding the status quo.

Ultimately, all these living wills are likely to achieve is to illustrate further that that our largest financial institutions still constitute a time bomb, ticking quietly near the center of the global economy.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

Read more opinion online from Bloomberg View. Subscribe to receive a daily e-mail highlighting new View editorials, columns and op-ed articles.

Today’s highlights: the editors on whether it’s a penalty or a tax and the latest jobs report; William D. Cohan on Finra’s captive arbitration system; Susan P. Crawford on whether Google is a monopoly; Albert R. Hunt on gaming the Electoral College; Pankaj Mishra on the false promise of Asian values; Jed Kolko on the downside of rising house prices.

To contact the writer of this article: Simon Johnson at sjohnson@mit.edu.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.

La fin de l'euro approche: Guide de survie

2012-05-28T11:18:31-04:00

Chaque crise économique débouche sur une prise de conscience collective. En Europe, ce moment approche. Des millions de personnes devront bientôt faire face au chaos et admettre que l'euro, tel que nous l'avons connu, est chose du passé.

Pour comprendre le pourquoi de cette situation, il faut avant tout perdre quelques illusions. Jusqu'à maintenant, la crise de la dette européenne s'est traduite par une série de « moments charnières », qui devraient plutôt être qualifiés de « marches d'escalier » descendant toujours plus bas. Le deuxième round des élections législatives grecques, qui aura lieu le 17 juin, constitue l'une de ces marches vers l'abîme. Malgré que les partis en faveur du plan de sauvetage figurent en tête des sondages, il apparaît certain qu'une nouvelle monnaie va bientôt circuler dans les rues d'Athènes. La Grèce ne pourra tout simplement pas demeurer dans la zone euro. En effet, les épargnants retirent leur argent des banques nationales et les contribuables diffèrent leurs paiements d'impôt. Les entreprises tardent à payer leurs fournisseurs - parce qu'elles n'en ont plus les moyens ou parce qu'elles espèrent régler bientôt leurs comptes à l'aide de drachmes dévalués.

La troïka composée de la Commission européenne (CE), de la Banque centrale européenne (BCE) et du Fonds monétaire international (FMI) s'est montrée incapable de relancer l'économie grecque, et tout nouveau plan de sauvetage financier risque de se heurter aux mêmes écueils. Dans un moment de frustration, la directrice générale du FMI Christine Lagarde a dit : « En ce qui concerne les Grecs, je pense aussi à tous ces gens qui essaient tout le temps d'échapper aux taxes ».

Mme Lagarde a épuisé son capital d'empathie, ce qui est absolument regrettable. La monnaie unique ne convient pas à l'Europe, et c'est ce que la débâcle grecque nous démontre par-dessus tout. La « dévaluation interne » (un euphémisme pour « coupures budgétaires massives ») devait favoriser la compétitivité et faciliter le paiement des dettes, mais le coût humain en est beaucoup trop élevé.

Après cinq ans de récession et de promesses non tenues, le taux de chômage dépasse maintenant 20 pour cent et les nouvelles mesures d'austérité promettent d'aggraver la situation. Dans ce contexte, il est normal que le mécontentement se fasse sentir dans les urnes. Et puisque le FMI, la Commission européenne et la presse financière spéculent sur une sortie possible de la zone euro, quel investisseur serait assez imprudent pour signer des contrats à long terme en Grèce en ce moment?

Bon nombre de politiciens européens prétendent qu'une sortie ordonnée de la Grèce est possible, et que ce pays sera le seul à faire défaut. Ils ont tort. La sortie de la Grèce n'est qu'une étape de plus menant à la dissolution chaotique de la zone euro.

À la prochaine étape de la crise, les électeurs européens prendront conscience des risques financiers énormes qu'ils doivent assumer afin de renflouer la monnaie unique. En quittant la zone euro, le gouvernement grec cessera de rembourser les 121 milliards d'euros qu'il doit aux créanciers privés, ainsi que les 27 milliards d'euros qu'il doit au FMI.

Mais ce n'est pas tout. Les Allemands, en particulier, apprendront avec stupéfaction que la Grèce cessera de rembourser les 155 milliards d'euros dus à l'Eurosystème, composé de la BCE et des 17 banques centrales des États membres. Ce montant inclut 110 milliards d'euros alloués discrètement à la Grèce par l'entremise du système de transferts automatisés Target 2. Tel que mentionné plus haut, les épargnants quittent actuellement les banques grecques en grand nombre, et ce mécanisme de compensation permet d'éviter leur faillite. Target 2 repose sur les banques centrales des États membres. Puisque l'Allemagne récolte la part du lion des capitaux en fuite, la Bundesbank assume la majeure partie des prêts à risque, mais les autres banques centrales seront tout aussi vulnérables en cas de défaut.

La BCE dément fermement avoir pris des risques inconsidérés. Or, si l'on additionne à Target 2 les obligations souveraines achetées pour renflouer les pays périphériques (Irlande, Espagne, Italie et Portugal), les créances douteuses de l'Eurosystème s'élèvent à 1,1 billion d'euros, ce qui équivaut à 200 pour cent de ses capitaux propres. (Nous avons fait cette estimation à partir des données officiellement disponibles.) Ces créances équivalent grosso modo à 43 pour cent du PIB allemand, qui s'élève à 2,57 billions d'euros. Aucune banque responsable n'oserait affirmer qu'un telle situation est sans risque pour les contribuables et les investisseurs.

La semaine dernière, le ministre des Finances polonais Jacek Rostowski a mis en garde ses collègues et affirmé qu'un défaut de la Grèce pourrait entraîner une fuite de capitaux, voire un effondrement du marché obligataire dans tous les pays périphériques. Pour éviter que le fléau ne se propage, tous les membres restants devraient avoir accès à un crédit illimité pour une période d'au moins 18 mois. M. Rostowski se dit toutefois inquiet, car la BCE ne semble pas en mesure de fournir un tel pare-feu, et aucune autre institution n'a la capacité, la légitimité ou la volonté de prendre le relais.

Pour la plupart des observateurs, il devient évident que la BCE, déjà submergée de créances douteuses, ne fournira pas un crédit illimité à tous les gouvernements en mauvaise posture financière. La trajectoire grecque - de l'austérité à la dépression à la cessation de paiement - risque de se reproduire ailleurs. Dans un tel contexte, pourquoi les Allemands permettraient-ils à la BCE de doubler ou quadrupler ses prêts à risque?

Le scénario le plus probable est que la BCE prêtera de l'argent d'une manière sporadique, ce qui ne suffira pas à stabiliser la situation. Sachant que la BCE et les contribuables allemands ne peuvent pas assumer des pertes à l'infini, les épargnants et les investisseurs vont tout simplement déserter les banques de la périphérie aussitôt que la débâcle grecque fera ses ravages.

Cette fuite de capitaux, qui pourrait durer plusieurs mois, obligera les institutions encore solvables à resserrer leur crédit, ce qui plongera les économies espagnole et italienne dans une récession encore plus profonde. Les électeurs de ces pays manifesteront assurément leur colère.
Par ailleurs, la réticence de la BCE à fournir une grande quantité de capitaux « visibles » n'empêchera nullement le système Target 2 de fonctionner. Cela veut dire que la Bundesbank continuera de prêter officieusement des sommes astronomiques à l'Italie (Banca d'Italia) et à l'Espagne (Banco de España). Les contribuables allemands risquent d'être effrayés par le risque que comporte une telle situation.
Bref, la fin de la zone euro ressemblera probablement à ce qui suit : les pays de la périphérie souffriront d'une récession économique de plus en plus grave et seront incapables de respecter les barèmes budgétaires établis par la troïka. Leurs taux d'endettement insoutenables les mèneront vers la faillite. Pendant ce temps, le cours de l'euro chutera par rapport aux autres devises, mais pas suffisamment pour rendre l'Europe plus attrayante pour les investisseurs.

Au contraire, la BCE donnera l'impression d'avoir perdu le contrôle de la situation, à force d'effectuer des prêts ne pouvant pas être entièrement remboursés. Le reste de la planète cessera de considérer l'euro comme une devise fiable. Les obligations européennes seront délaissées, à tel point que l'Allemagne elle-même pourrait avoir de la difficulté à financer ses opérations à des taux d'intérêts abordables. Par conséquent, les Allemands subiront un taux d'inflation inacceptable, et seront de plus en plus réticents à renflouer leurs partenaires européens.

La solution la plus simple serait que l'Allemagne claque elle-même la porte, ce qui obligerait les autres membres de la zone euro à se débrouiller pour en faire de même. Or les Allemands éprouvent un fort sentiment de culpabilité par rapport aux guerres du siècle dernier, ainsi qu'un grand attachement aux bénéfices de 60 ans d'intégration européenne. Ils vont tout faire pour retarder l'inévitable. Malheureusement, quand l'inévitable surviendra, le chaos économique et les antagonismes politiques seront encore plus intenses.

Pour les marchés financiers planétaires, un éclatement désordonné de la zone euro aura des conséquences beaucoup plus graves que la crise de l'automne 2008. Cette année-là, les gouvernements ont dû renflouer de grandes institutions privées, ce qui a sauvé du même coup les créanciers de ces grandes institutions. Mais en ce moment, les gouvernements européens eux-mêmes frôlent la faillite.

Le PIB de l'Union européenne s'élève à un tiers du PIB global. Le total des dettes souveraines non acquittées de la zone euro équivaut à 11 billions de dollars, dont 4 peuvent être considérés comme un risque à très court terme. Les marchés financiers européens sont très ramifiés, et leurs produits dérivés libellés en euros totalisent 185 billions de dollars. En cas d'éclatement de la zone euro, on peut donc prévoir une fuite de capitaux massive en direction des États-Unis et de l'Asie. Est-ce que les grandes institutions bancaires de ce monde seront en mesure d'absorber un tel choc?

Il est possible qu'un grand nombre de ménages et de retraités perdent la totalité de leurs investissements - à moins que l'inflation ne gruge leur pouvoir d'achat. Peu importe la situation, de fortes turbulences politiques sont à prévoir.

Depuis trois ans déjà, les politiciens européens promettent de faire « tout ce qu'il faut » pour sauver l'euro. Mais il est évident que leurs promesses sont impossibles à tenir, car les mesures d'austérité requises entraîneraient à coup sûr de cuisantes défaites électorales. Combien de temps vont-ils réussir à retarder l'inévitable effondrement de l'euro ? Quelques mois ou plusieurs années encore ? Qu'importe, la fin sera tragique.

Lorsque le chaos s'installe, il devient tentant de blâmer le voisin. Un certain nombre de dirigeants européens - incluant Mme Lagarde - ont d'ores et déjà commencé à couvrir leurs arrières. Il est facile de pointer les Grecs du doigt, et d'affirmer que leur évasion fiscale est à l'origine de la crise. Mais cela est faux. L'euro a aussi créé des pertes d'emplois massives et des récessions graves en Irlande, en Italie, en Espagne et au Portugal. Malgré les programmes d'ajustement proposés par la troïka, les conditions économiques de tous les pays périphériques continuent de se dégrader. Quelques politiciens grecs corrompus ne peuvent être la source de tous ces maux.

Il est grand temps que les politiciens et technocrates européens - aidés en cela par les États-Unis et quelques autres puissances - commencent à planifier la fin de la zone euro. Cette opération ne sera pas parfaitement ordonnée, loin s'en faut. Mais il existe des manières de limiter les dégâts aux plans légal, technique et financier. Il faudra planifier à l'avance l'introduction de nouvelles monnaies nationales, la gestion des défauts de paiement en série, la restructuration du capital des banques et des firmes d'assurance, ainsi que le partage de l'actif et du passif de l'Eurosystème. Les monnaies nationales devront être adossées à des réserves en devises étrangères. Bref, l'Europe devra s'extirper du bourbier causé par la monnaie unique, tout en préservant ses formidables acquis que sont le libre échange et la mobilité de la main d'œuvre.
Malheureusement pour nous tous, les politiciens détestent admettre leurs erreurs (si ce n'est leur incompétence). La tâche de coordonner 17 pays en discorde pour trouver une issue à cette crise est sans doute trop ambitieuse. Oubliez un plan de sauvetage concocté par le G8 ou le G20. Oubliez la restructuration à grande échelle des dettes, la vente d'obligations européennes ou tout autre conte de fées. Nous sommes livrés à nous-mêmes, c'est sauve qui peut!

Simon Johnson est le co-auteur du livre White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, disponible en librairie depuis le 3 avril. Ce billet a également été publié dans The Baseline Scenario. Vous pouvez découvrir plus d'articles de cette nature dans la section Fiscal Affairs de notre édition américaine. Peter Boone est le président d'Effective Intervention, une organisation de bienfaisance britannique. Il occupe un poste de directeur au sein de Salute Capital Management Limited, et est également associé de recherche au Centre for Economic Performance de la London School of Economics.

The End of the Euro: A Survivor's Guide

2012-05-27T17:56:53-04:00

In every economic crisis there comes a moment of clarity. In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone. Economic chaos awaits them.

To understand why, first strip away your illusions. Europe's crisis to date is a series of supposedly "decisive" turning points that each turned out to be just another step down a steep hill. Greece's upcoming election on June 17 is another such moment. While the so-called "pro-bailout" forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens. It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers -- either because they can't pay or because they expect soon to be able to pay in cheap drachma.

The troika of the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF) has proved unable to restore the prospect of recovery in Greece, and any new lending program would run into the same difficulties. In apparent frustration, the head of the IMF, Christine Lagarde, remarked last week, "As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time."

Ms. Lagarde's empathy is wearing thin and this is unfortunate -- particularly as the Greek failure mostly demonstrates how wrong a single currency is for Europe. The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange "internal devaluations" (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.

Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural. With IMF leaders, EC officials, and financial journalists floating the idea of a "Greek exit" from the euro, who can now invest in or sign long-term contracts in Greece? Greece's economy can only get worse.

Some European politicians are now telling us that an orderly exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves. They are wrong. Greece's exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone.

During the next stage of the crisis, Europe's electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive. When Greece quits the euro, its government will default on approximately 121 billion euros of debt to official creditors, and about 27 billion euros owed to the IMF.

More importantly and less known to German taxpayers, Greece will also default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone). This includes 110 billion euros provided automatically to Greece through the Target2 payments system -- which handles settlements between central banks for countries using the euro. As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail. This role is taken on by other euro area central banks, which have quietly lent large funds, with the balances reported in the Target2 account. The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data). This amounts to over 200 percent of the (broadly defined) capital of the euro system. No responsible bank would claim these sums are minor risks to its capital or to taxpayers. These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros. With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.

Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that -- to avoid a greater calamity -- all remaining member nations need to be provided with unlimited funding for at least 18 months. Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.

We agree: Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market. The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere -- so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?

The most likely scenario is that the ECB will reluctantly and haltingly provide funds to other nations -- an on-again, off-again pattern of support -- and that simply won't be enough to stabilize the situation. Having seen the destruction of a Greek exit, and knowing that both the ECB and German taxpayers will not tolerate unlimited additional losses, investors and depositors will respond by fleeing banks in other peripheral countries and holding off on investment and spending.

Capital flight could last for months, leaving banks in the periphery short of liquidity and forcing them to contract credit -- pushing their economies into deeper recessions and their voters towards anger. Even as the ECB refuses to provide large amounts of visible funding, the automatic mechanics of Europe's payment system will mean the capital flight from Spain and Italy to German banks is transformed into larger and larger de facto loans by the Bundesbank to Banca d'Italia and Banco de Espana -- essentially to the Italian and Spanish states. German taxpayers will begin to see through this scheme and become afraid of further losses.

The end of the euro system looks like this. The periphery suffers ever deeper recessions -- failing to meet targets set by the troika -- and their public debt burdens will become more obviously unaffordable. The euro falls significantly against other currencies, but not in a manner that makes Europe more attractive as a place for investment.

Instead, there will be recognition that the ECB has lost control of monetary policy, is being forced to create credits to finance capital flight and prop up troubled sovereigns -- and that those credits may not get repaid in full. The world will no longer think of the euro as a safe currency; rather investors will shun bonds from the whole region, and even Germany may have trouble issuing debt at reasonable interest rates. Finally, German taxpayers will be suffering unacceptable inflation and an apparently uncontrollable looming bill to bail out their euro partners.

The simplest solution will be for Germany itself to leave the euro, forcing other nations to scramble and follow suit. Germany's guilt over past conflicts and a fear of losing the benefits from 60 years of European integration will no doubt postpone the inevitable. But here's the problem with postponing the inevitable -- when the dam finally breaks, the consequences will be that much more devastating since the debts will be larger and the antagonism will be more intense.

A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008. In fall 2008 the decision was whether or how governments should provide a back-stop to big banks and the creditors to those banks. Now some European governments face insolvency themselves. The European economy accounts for almost 1/3 of world GDP. Total euro sovereign debt outstanding comprises about $11 trillion, of which at least $4 trillion must be regarded as a near term risk for restructuring.

Europe's rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia. Who can be confident that our global megabanks are truly ready to withstand the likely losses? It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.

For the last three years Europe's politicians have promised to "do whatever it takes" to save the euro. It is now clear that this promise is beyond their capacity to keep -- because it requires steps that are unacceptable to their electorates. No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.

Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF's leadership are already covering their tracks, implying that corruption and those "Greeks not paying taxes" caused it all to fail. This is wrong: the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also. Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery. We cannot blame corrupt Greek politicians for all that.

It is time for European and IMF officials, with support from the U.S. and others, to work on how to dismantle the euro area. While no dissolution will be truly orderly, there are means to reduce the chaos. Many technical, legal, and financial market issues could be worked out in advance. We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system. Some nations will soon need foreign reserves to backstop their new currencies. Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.

Unfortunately for all of us, our politicians refuse to go there -- they hate to admit their mistakes and past incompetence, and in any case, the job of coordinating those seventeen discordant nations in the wind down of this currency regime is, perhaps, beyond reach.

Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualization scheme, or any other bedtime story. We are each on our own.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario. Read more from the Fiscal Affairs series here. Peter Boone is chair of Effective Intervention, a UK-based charity, an associate at the Centre for Economic Performance, London School of Economics, and a principal in Salute Capital Management Limited.

Jamie Dimon Should Resign From the Board Of The New York Fed

2012-05-21T08:04:40-04:00

Jamie Dimon, CEO of JP Morgan Chase, is a member of the board of the New York Federal Reserve Bank. Mr. Dimon's role there is sometimes presented as "advisory" but he sits on the Management and Budget Committee; here is the committee's charter, which includes reviewing and endorsing "the framework for compensation of the Bank's senior executives (Senior Vice President and above)". His advice apparently extends to important aspects of how the New York Fed operates, including aspects of its personnel policies.

The New York Fed is a key part of our regulatory and supervisory apparatus, involved in overseeing the activities of banks and bank holding companies, like JP Morgan Chase (currently the largest bank in the US). Within the Federal Reserve System, the New York Fed also has some of the deepest expertise on financial markets and complex products, such as derivatives. Almost of the relevant supervision takes place behind closed doors, with representatives of the industry - including big banks - typically taking the position that they should be allowed to operate in a particular way or use various kinds of risk models. The staff of the New York Fed often has a decisive voice in determining what kinds of risks are acceptable for systemically important financial institutions.

In recent weeks, risk management apparently broke down completely at JP Morgan Chase. Even the most sympathetic accounts portray Mr. Dimon as out of touch with large parts of his business. There are also press reports that one or more of Mr. Dimon's hand-picked executives failed to understand and report on risks that became greatly magnified and quickly got out of control. Puzzles remain about what exactly Mr. Dimon did not know and when he did not know it, including the question of whether he disclosed all adverse material information in a timely and appropriate manner. Presumably, the New York Fed will be involved - directly or indirectly - in ongoing and future investigations (including answering questions about what its staff did or did not know).

At the end of last week, Treasury Secretary Tim Geithner called for Mr. Dimon to step down from the board of the New York Fed. Mr. Geithner is former president of the New York Fed and fully understands how the board operates - and how big bankers win friends and influence people. Mr. Geithner spoke in the usual Treasury Department diplomatic code - he suggested there is a "perception" problem that must be addressed. To officials, this is as clear a statement as is needed. As chairman of the Financial Stability Oversight Council, Mr. Geithner is ultimately responsible for the health of the financial system and its systemically important components. He is telling Mr. Dimon to go.

Mr. Dimon is likely to resist, but the blatant conflicts of interest in the current situation are too great. Mr. Dimon should not be in any position to influence or affect an organization that plays such an essential role in overseeing the activities of his company. Given the evident breakdowns in risk management at JP Morgan Chase and the possibility that there were again problems with bank supervision in this instance, we need to have a proper independent investigation - and to changes the parameters of this banker-supervisor relationship going forward.

To have Mr. Dimon involved in overseeing the management of the New York Fed, an organization that oversees his activities, decisions, and potential losses, is no longer acceptable. We do not accept such conflicts of interest in other parts of American society and we should not accept them in this instance.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario. Read more from the Fiscal Affairs series here.

Geithner to Dimon: Resign From the Board of the New York Fed

2012-05-17T22:27:28-04:00

In an interview Thursday on PBS NewsHour, Jeffrey Brown and Treasury Secretary Tim Geithner had the following exchange:

"JEFFREY BROWN: Do you think Jamie Dimon should be off the board [of the New York Federal Reserve Board]?

TIMOTHY GEITHNER: Well, that's a question he'll have to make and the Fed will have to make. But again, on the basic point, which is it is very important, particularly given the damage caused by the crisis, that our system of oversight and safeguards and the enforcement authorities have not just the resources they need, but they are perceived to be above any political influence and have the independence and the ability to make sure these reforms are tough and effective so we protect the American people, again, from a crisis like this. And we're going to, we're going to do that."

In the diplomatic language of Treasury communications, Mr. Geithner just told Jamie Dimon to resign from the New York Fed board (here is the current board composition). It looks bad -- and it is bad -- to have him on the board of this key part of the Federal Reserve System at a time when his bank is under investigation with regard to its large trading losses and the apparent failure of its risk management system.

Mr. Geithner's call is a major and perhaps unprecedented development which can go in one of two ways.

If Mr. Dimon resigns, that is a major humiliation and recognition -- at the highest levels of government -- that even the country's best connected banker has overstepped his limits. This would be a major victory for democracy and a step towards reopening the debate on financial reform, including introducing more restrictions on what global megabanks can do.

In modern American politics, symbols and substance are hard to disentangle. The big banks have won many rounds, so many times in recent years -- including with the help of Mr. Geithner at key moments during the Dodd-Frank debate, in subsequent discussions over capital requirements, and with regard to design and potential implementation of the Volcker Rule (which would limit proprietary trading and other forms of excessive risk taking by big banks). If Mr. Dimon resigns, this could help open the doors to a broader reevaluation of power in the hands of Too Big To Fail banks -- and how they undermine the rest of our economy.

If, as seems more likely, Mr. Dimon stays in place, that would be a great victory for the big banks -- and a reminder of who is really in charge of the country. Mr. Geithner will be forced to walk back from his statement; that would not exactly inspire confidence in our officials -- or help President Obama get re-elected.

Keep in mind that Mr. Dimon himself decided to transform the relevant part of JP Morgan Chase into a risk-taking operation -- and it is the people he chose and the systems he put in place that have now blown up.

The entire record of recent interactions between JP Morgan Chase and the New York Federal Reserve will presumably be looked at by investigators -- including the total number of meetings, the precise content, and the involvement of Mr. Dimon himself. For example, how often did Mr. Dimon meet with Bill Dudley, president of the New York Fed, over the past 12 months, either one-on-one or in a group meeting? What exactly was discussed? How did any of these interactions filter down into the supervisory process?

We need an independent investigation of the JP Morgan losses -- as I argued Thursday morning on NYT.com's Economix blog. This investigation should examine, among other things, the relationship between Mr. Dimon, his bank, and the New York Fed.

Who will prove more powerful, Jamie Dimon or Tim Geithner?

JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking

2012-05-11T08:22:50-04:00

Experienced Wall Street executives and traders concede, in private, that Bank of America is not well run and that Citigroup has long been a recipe for disaster. But they always insist that attempts to re-regulate Wall Street are misguided because risk-management has become more sophisticated -- everyone, in this view, has become more like Jamie Dimon, head of JP Morgan Chase, with his legendary attention to detail and concern about quantifying the downside.

In the light of JP Morgan's stunning losses on derivatives, announced yesterday but with the full scope of total potential losses still not yet clear (and not yet determined), Jamie Dimon and his company do not look like any kind of appealing role model. But the real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.

JP Morgan claimed to have great risk management systems -- and these are widely regarded as the best on Wall Street. But what does the "best on Wall Street" mean when bank executives and key employees have an incentive to make and misrepresent big bets -- they are compensated based on return on equity, unadjusted for risk? Bank executives get the upside and the downside falls on everyone else -- this is what it means to be "too big to fail" in modern America.

The Federal Reserve knows this, of course -- it is stuffed full of smart people. Its leadership, including Chairman Ben Bernanke, Dan Tarullo (lead governor for overseeing bank capital rules), and Bill Dudley (president of the New York Fed) are all well aware that bankers want to reduce equity levels and run a more highly leveraged business (i.e., more debt relative to equity). To prevent this from occurring in an egregious manner, the Fed now runs regular "stress tests" to assess how much banks could lose - and therefore how much of a buffer they need in the form of shareholder equity.

In the spring, JP Morgan passed the latest Fed stress tests with flying colors. The Fed agreed to let JP Morgan increase its dividend and buy back shares (both of which reduce the value of shareholder equity on the books of the bank). Jamie Dimon received an official seal of approval. (Amazingly, Mr. Dimon indicated in his conference call on Thursday that the buybacks will continue; surely the Fed will step in to prevent this until the relevant losses have been capped.)

There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses. We still do not know the exact source of this disaster, but it appears to involve credit derivatives -- and some reports point directly to credit default swaps (i.e., a form of insurance policy sold against losses in various kinds of debt.) Presumably there are problems with illiquid securities for which prices have fallen due to recent pressures in some markets and the general "risk-off" attitude - meaning that many investors prefer to reduce leverage and avoid high-yield/high-risk assets.

But global stress levels are not particularly high at present -- certainly not compared to what they will be if the euro situation continues to spiral out of control. We are not at the end of a big global credit boom -- we are still trying to recover from the last calamity. For JP Morgan to have incurred such losses at such a relatively mild part of the credit cycle is simply stunning.

The lessons from JP Morgan's losses are simple. Such banks have become too large and complex for management to control what is going on. The breakdown in internal governance is profound. The breakdown in external corporate governance is also complete -- in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign. No doubt Jamie Dimon will remain in place.

And the regulators also have no idea about what is going on. Attempts to oversee these banks in a sophisticated and nuanced way are not working.

The SAFE Banking Act, re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the nail on the head. The discussion he instigated at the Senate Banking Committee hearing on Wednesday can only be described as prescient. Thought leaders such as Sheila Bair, Richard Fisher and Tom Hoenig have been right all along about "too big to fail" banks (see my piece from the NYT.com on Thursday on SAFE and the growing consensus behind it).

The Financial Services Roundtable, in contrast, is spouting nonsense -- they can only feel deeply embarrassed today. Continued opposition to the Volcker Rule invites ridicule. It is immaterial whether or not this particular set of trades by JP Morgan is classified as "proprietary"; all megabanks should be presumed incapable of managing their risks appropriately.

Dennis Kelleher and Better Markets are right about the broad need for implementing Dodd-Frank and they are particularly right about the problems that surround non-transparent derivatives (follow them @bettermarkets for some of the smartest lines and best links as the JP Morgan debacle continues to develop). The Better Markets press release on Thursday night put the entire situation in a nutshell:

"Jamie Dimon and JP Morgan Chase just proved what anyone not getting a paycheck from a Wall Street bank already knows: gigantic too-big-to-fail banks are too-big-to-manage."

Anat Admati and her colleagues at Stanford (and her growing band of supporters in the US and around the world) are right about bank capital. The people in charge of Federal Reserve policy in this regard are dead wrong -- perhaps because they spend far too much time talking to Jamie Dimon and his fellow executives, while consistently refusing to engage with their better informed critics.

Ms. Admati skewered Jamie Dimon at length and in detail 18 months ago on exactly these issues. You must read her original Huffington Post piece. She has been relentless ever since -- see this material. She was right then and she is right now: we need much higher capital requirements and much simpler rules -- focus on limiting leverage. Big banks should be forced to become smaller -- small enough and simple enough to fail.

It is time for the Federal Reserve to move its policy on these issues.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. This post is cross-posted from The Baseline Scenario.

Fiscal Affairs: The Buffett Rule Is a Good Idea

2012-04-16T09:23:42-04:00

Some high income Americans pay a lot of tax; others do not. If you have right tax advice and if most of your income can be structured as some form of "capital gains," your marginal rate -- what you pay on the your last dollar of income -- may be very low. The highest marginal income tax rate currently is 35 percent, while long-term (over a year) capital gains are taxed at 15 percent at most.

The Buffett Rule is a proposal to establish a minimum tax rate for "millionaires" -- people earning more than $1 million per year -- and the Senate is likely to vote on a version this week. The exact amount of revenue that this would bring in depends on the details, but there is no question that it is small relative to the country's need to control the federal budget. (The Joint Committee on Taxation scored one version of this proposal as generating about $30 billion over 10 years; the annual budget deficit will remain over $1 trillion in the near term even under the most optimistic projections.)

The biggest sticking point for any reasonable strategy to control the U.S. federal budget is that one side -- the Republicans -- steadfastly refuse to raise taxes, at all and on anyone.

There are three ways forward. Either the Republicans begin to compromise -- and agree to raise taxes as part of a comprehensive deficit reduction and debt control strategy, just as Ronald Reagan did. There is a great deal of confusion about whether Reagan raised taxes after first cutting them; see chapter 3 of White House Burning for the details of what actually happened.

Or the Republicans who have signed the Taxpayer Protection Pledge will prevail -- no one's taxes will go up and, most likely, some people's taxes will go down. In this case, either the deficit will continue to grow (which is what Newt Gingrich is proposing) or Medicare and almost everything else the federal government does will be scrapped (which is the position represented by Paul Ryan). My guess is that, in this scenario, we will say farewell to any meaningful form of social insurance -- good luck getting healthcare when you are 85 (unless you earned over a million dollars a year for many years).

Or the Republicans will lose big -- and fiscal consolidation can proceed without them.

A complete loss of support for the Republicans seems unlikely -- they will surely hold more than 40 seats in the Senate for the foreseeable future.

So the fiscal trajectory of the country -- and whether Social Security and Medicare survive -- depends very much on whether the Republicans will compromise on taxes.

The Buffett Rule is a tiny tax, of little consequence to the people who would pay it or to the country as a whole. The idea that $30 billion of additional revenue would tip the balance in any way is simply ludicrous.

But this is precisely what gives the Buffett Rule its powerful symbolism.

Much of federal government public finance is complex and hard for people to comprehend -- demystifying deficits and debt is a major reason we wrote White House Burning. Some of the reaction to our book is encouraging, particularly from people who are willing to spend some time with the details.

But the question behind the Buffett Rule is crystal clear and does not require you to buy a book or even read the newspaper. Should all high income Americans pay a moderate level of tax?

Jim Yong Kim for the World Bank

2012-04-15T11:15:26-04:00

A decision on choosing the next president of the World Bank is expected this week -- perhaps as early as Monday. The Obama administration nominated Jim Yong Kim, president of Dartmouth College and a noted public health expert. The reaction to this nomination from development economists and people experienced in the business of lending to poor countries has been overwhelmingly negative.

They are making a big mistake. Mr. Kim would make an excellent World Bank president.

There are three issues. First, should the president of the World Bank continue to be an American? Second, should this position be held by someone with a primary background in economics and finance? Third, should this job go to a person -- like Mr. Kim -- who has specialized on public health?

The job of running the World Bank should not necessarily go to an American -- just as the job of managing director at the International Monetary Fund should not be presumed to go to a European. The divvying up of these important positions is a de facto arrangement that became established in the 1940s and 1950s, but it has really outlived its appropriateness.

There should be an open competition for both positions -- and Mr. Kim faces appropriately strong competition from Ngozi Okonjo-Iweala, a well-respected Nigerian finance minister and former senior official at the World Bank.

There is no question that the White House wants this job to go to an American, mostly because no administration likes to be the one to give up such prerogatives. And gone are the days when anyone put up by the United States would necessarily be chosen -- even the controversial Paul Wolfowitz went through with surprisingly little push back, although he ran into trouble subsequently.

But Mr. Kim is a brilliant nomination, precisely because he is so far from the mold of standard World Bank presidents. For a full write-up of his accomplishments, see this piece by Anjali Sastry and Rebecca Weintraub. (Sastry is one of my colleagues at MIT, where she teaches a very successful course that integrates global health and management issues, follow her @anj_sas; Weintraub is a physician and prominent public health specialist.)

The World Bank does not need "more of the same" in terms of vision from its leadership. Like it or not, the World Bank will continue to issue bonds and make loans to countries for infrastructure and other projects, typically at an interest rate that is somewhat below what is being charged by the private sector. It will also try to raise donor funds that can be shared with very poor countries, preferably in a productive manner.

The World Bank will also continue to struggle having a profound impact on people's lives with these standard development lending activities. To understand this point, look at two books. Bill Easterly's The Elusive Quest for Growth is a brilliant account of what has gone wrong -- repeatedly -- with thinking about development, including but not limited to the World Bank. Daron Acemoglu and Jim Robinson's new bestseller, Why Nations Fail, provides all you need to know -- and probably more than you can stomach -- about why some countries stay so poor. The very sad truth is that powerful people in some places do very well, in their own estimation, when the rest of the country remains in ruins. And there is nothing the World Bank -- or anyone else in development economics -- can do to break through and share prosperity more broadly in those places. (You can follow Easterly and Acmeoglu/Robinson on twitter: @bill_easterly and @WhyNationsFail; the conversation around @WhyNationsFail is particularly lively and informative at present.)

But public health is different. In contrast to the lack luster performance of development economics over the past half century, public health intellectuals and officials have completely transformed health outcomes around the world. This process started early in the 20th century but really picked up pace in the 1940s and 1950s (for more historical background and medical details, see "Disease and Development," a 2007 paper co-authored with Daron Acemoglu.)

The very poorest people in the world did not participate fully in this global health transformation -- partly because of the problems outlined in Why Nations Fail. But leaders like Mr. Kim -- and in fact Mr. Kim himself -- are leading a second breakthrough, in which better health services are being delivered even to very poor people in some of the most difficult conditions imaginable.

There is a great deal more to be done. The World Bank does good work supporting public health initiatives, but it could do much more. If Mr. Kim becomes World Bank president -- and preferably stays in that position for a decade -- we should expect to see a great deal more progress.

The task now is to mobilize private donors, pharmaceutical companies, and officials in a robust coalition focusing on improving health and increasing life expectancy. The mortality of children under the age of five is likely to be a top priority in that context. Reducing maternal mortality should also get a great deal of attention.

All of this is completely achievable. Public health has done well in the past half century. We should provide more resources and encourage greater success. Save and improve millions of lives.

Mr. Kim is exactly the right person to lead the next transformation of global health outcomes.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available now. This post is cross-posted from The Baseline Scenario.

Volcker Rule Would Cause Irreparable Damage to the Muppets -- and Much More Broadly

2012-04-01T13:00:25-04:00

A major new research report -- released this weekend by the renowned international consulting firm, IMS -- finds conclusively that implementation of the proposed Volcker Rule would damage not just the irreplaceable Muppets but also "all children-oriented television or other media-based educational program content."

The logic in the report is straightforward and, quite frankly, compelling. The Volcker Rule -- which aims to limit proprietary trading and excessive risk-taking by the country's largest banks -- would reduce the ability of "too big to fail" institutions to bet heavily on the price of commodities used to produce puppets (mostly cotton, but also apparently wood, aluminum, and some rare earths).

"In response to the changing demands of their customers, banks have expanded their role of providing financial resources and services to include risk management and intermediation services to [various kinds of puppets](p. ES2)

These services are highly profitable and of great value to the skilled artisans who produce puppets, but if the very biggest banks are not allowed to engage in these activities, then no one else will.

This, of course, is elementary economics -- dating back as far as Adam Smith. If there is a profit-making opportunity to be had, then everyone will spurn it, unless they work for a massive international bank.

The history of the United States is replete with examples of business sectors that would never have come into existence were it not for the proprietary trading of banks that were large enough to damage the economy when they failed.

Thomas Edison worked long and hard for J.P. Morgan (the man) before being allowed into the speculative trading side of the business. Henry Ford's entire model was a spin-off from Bankers' Trust -- with a substantial equity investment from his former employer. And the Wright Brothers' business concept -- as well as their most basic notions of aeronautics -- derived from their early work with paper airplanes on the trading floor of what became First National City Bank of New York (i.e., Citigroup today).

Put simply, there has never been real entrepreneurship in the U.S. financial markets or economy -- other than what these banks have put there, directly or indirectly. The fact these banks were very small relative to the economy until the 1980s is irrelevant.

And the fact that these banks now draw on huge government implicit subsidies -- while also creating an enormous and dangerous tax payer liability -- is neither here nor there. Malfeasance by these banks has brought us to the brink of fiscal disaster. In political terms, we are manipulated by bankers just as if they are pulling our strings.

But you have to consider the benefits, as well as the costs. Do you enjoy watching the Muppets or not?

If the Volcker Rule is implemented as planned, that would have a major negative effect on the bond yields -- the spread over the "risk-free" interest rate -- paid by the Muppets and other leading providers of children's entertainment. No one else will ever trade these bonds to any significant degree -- just as no one would have produced cars or planes without the dominance of big banks in those sectors. Even the electricity you are using to read this piece was made possible by the market dominance and overbearing presence of deeply entrepreneurial and ethical entities such as Enron.

The Muppets themselves have come out strongly in favor of the financial sector as currently structured.

As Lloyd Blankfein, head of Goldman Sachs, reportedly said recently:

"It's not the dealers and it's not the investment bankers and providers that have to grapple with regulation. It's users and [puppets of all kinds] in the market that have to deal with different margin requirements...have to deal with unfortunately and inevitably higher cost in managing their portfolios...and have to pay the price for the higher cost of holding inventories."

The IMS report was paid for by Morgan Stanley (see p. 3), further evidence of smart entrepreneurial investments by big banks that support the deeper development of the economy and help create puppets everywhere.

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario.

Fiscal Affairs: Last Ditch Attempt to Save a Little Bit of Investor Protection in the U.S.

2012-03-22T08:35:01-04:00

As it currently stands, the "JOBS" bill now before the Senate would gut investor protection in the United States. The title of the bill is a complete misnomer -- anything that weakens investor protection makes it more risky to invest in companies and increases the cost of capital to honest entrepreneurs. (For more background on the bill and links, see this piece.)

Much of the 1930s-era Securities legislation, which served us well for more than 70 years, is about to be repealed in a moment of bipartisan madness.

Almost all attempts to amend the House version of this legislation -- and to make it more favorable to investors -- have now failed in the Senate, and the "cloture motion" received more than 60 votes (so the bill cannot be filibustered). But Senator Jack Reed (D., Rhode Island) is leading one last charge to make the Senate version more reasonable.

Here is the issue with H.R. 3606 (as the House version of the bill is known), from Senator Reed's website:

The SEC requires public companies to disclose meaningful financial information to the public. This provides a common pool of knowledge for all investors to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate public information can people make sound investment decisions. The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation's economy. H.R. 3606 would roll back key investor protections, denying the public critical information that is essential to make sound judgments and would ultimately not lead to the proposed goal of the bill: providing for access to capital, particularly for small emerging companies.

The "JOBS" bill would permit even very large companies to avoid all public disclosures.

Amazingly, it would also exempt these companies from having to comply with the federal regulation regarding mergers and acquisition. Private equity firms would even be able to manipulate the market while making a tender offer for shares -- the kind of behavior that has really been taboo (and illegal) since the 1930s.

Senator Reed has put forward an amendment, #1931, that will at least partially retain some of our existing investor protections and disclosure requirements.

Specifically, Senator Reed's amendment would close or limit a major loophole that will allow large companies to avoid registering with the SEC (and therefore escape much regulation). The Reed Amendment would clarify how to define "shareholders" for the purpose of determining if a business is so widely owned that it must register with the SEC. Under the Amendment, the count should be based on beneficial owners of the shares, i.e., real people. The goal is to prevent evasion of the SEC registration threshold through "nominal" owners holding the shares for large numbers of beneficial owners.

Big companies like H.R. 3606 - they will be regulated less and if the cost of capital rises for start-ups, that actually helps them. The Chamber of Commerce, the American Bankers' Association, and the Independent Community Bankers of America have all weighed in heavily against the Reed Amendment - the idea of escaping SEC scrutiny greatly appeals to them.

The Chamber of Commerce's letter against the Amendment to Senators closes with this statement - or you might call it a threat (bold and underlining in the original):

The Chamber strongly opposes this amendment and may consider including votes on, or in relation to, this amendment in our How They Voted scorecard.

Under Senate rules, the Reed Amendment would need just 51 votes today in order to pass. But against this kind of corporate firepower, does this entirely reasonable Amendment have any chance?

Simon Johnson is the co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You, available from April 3rd. This post is cross-posted from The Baseline Scenario.