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Monday, March 8, 2010

Simon Johnson on Tim Geither's echo of the Bernanke line, "Saving the big banks will save the economy"

The refrain, "We averted the Great Depression by saving the big banks," has been spoken so often by so many it is taken as fact. Recent history is replete with examples of similar mantras that proved not to be the case. Tim Geithner is out with a new apology, but we need to remember the premise so many months ago, that focusing bailouts on the financial sector would refloat the economy. That promise has been quietly tabled in favor of the above, "We averted the Great Depression." Unfortunately, neither is true.
They Saved the Big Banks But Kind Of Lost The Economy Doing It
by Simon Johnson
Baseline Scenario
March 8, 2009

It would be easy to take relatively cheap shots at the portrayal of Tim Geithner — “we saved the economy but kind of lost the public doing it” — in the New Yorker, out today.

Mr. Geithner is quoted as saying, “Some on the left have fallen into a trap set by the Republicans, allowing voters to mistakenly think that the biggest part of the bank bailout had come under Obama rather Bush.” Mr. Geithner should know – as he spearheaded the saving of banks and other financial institutions under both Bush and Obama. In fact, it’s the continuation of George Bush’s policies by other means that really has erstwhile Obama supporters upset.

“I think there are some in the Democratic Party that think Tim and Larry are too conservative for them and that the President is too receptive to our advice.” Probably this is linked to the fact that Tim Geithner is not a Democrat.

Geithner also suggests that his critics compare government spending on different kinds of programs under President Obama: “By any measure, the Main Street stuff dwarfs the Wall Street stuff.” This insults our intelligence. Wall Street created a massive crisis and we consequently lost 8 million jobs; any responsible government would have tried hard to offset this level of damage with all available means. This includes fiscal measures that will end up increasing out privately held government debt, as a percent of GDP, by around 40 percentage points. It’s not the fiscal stimulus, broadly defined, that is Mr. Geithner’s problem – it’s the lack of accountability for the bankers and politicians who got us into this mess.
But the Geithner issues reflected here run much deeper. The New Yorker’s John Cassidy alludes to these but he may be too subtle. Here’s the less subtle version.

What exactly was the “Geithner stabilization plan” that frames the article – and is the basis for Secretary Geithner claiming to have saved anything? We are not really talking about the much vaunted but little used toxic asset/loan purchase program (the “PPIP”). “The plan” here means essentially the stress tests designed by Treasury and run by the Fed – which brought some transparency to banks’ balance sheets, but which also used a relatively benign “stress scenario” (watch commercial real estate, residential mortgages, and credit card losses now unfold).

The main feature of the plan, of course, was – following the stress tests – to communicate effectively that there was a government guarantee behind every major bank or quasi-bank in the United States. Of course this works in the short-term – investors like such guarantees. But there’s a good reason we usually don’t guarantee all financial institutions – or act happy when other countries do the same. Unconditional bailouts lead to trouble, encouraging reckless risk-taking and undermining responsible governance. You can’t run any form of reasonable market system when some big players hold “get out of bankruptcy free” cards.

All crises end – this is actually Larry Summers’s famous line. We avoided a Great Depression primarily because, compared with 1929-31, we have a government sector that is large relative to the economy – and which does not collapse when credit goes into freefall. What exactly did the Obama administration do in ending the crisis that a Clinton or McCain administration – or even Bush – would not have done? The most plausible answer is: Nothing.

Geithner insists, according to John Cassidy, that the Obama administration has “proposed the biggest regulatory overhaul in seventy-five years.” This is the worst conceit. The sad and unfortunate truth is quite the opposite – because Mr. Geithner and his colleagues refused to seize the moment and didn’t break the economic and political power of anyone who mattered, they have doomed us to re-run the same horrible credit loop as before. Legislation may tweak the details, but the regulation and control of systemic risk remains just as weak as before.

Is the Secretary of the Treasury completely unaware that our biggest banks have become even bigger? Why does he send out Herb Allison, long-time Merrill Lynch executive, and now an Assistant Secretary to say the US government has “no too big to fail bailout policy,” when this is patently not true? Why has he reshaped the details of the “Volcker Rules” so they are now meaningless?

In truth, “too big to fail” is not the worst thing we should fear – our financial institutions are now on their way to becoming “too big to save”. In 1929-30, even if the federal government had wanted to put in place a big fiscal stimulus, it could only have mounted something around 1 percent of GDP; the financial shock of that day was much bigger. Perhaps monetary policy in the early 1930s could have done more, but today we have already pushed “quantitative easing” (meaning that the Federal Reserve buys junk) beyond recorded limits. How much do you want to gamble that, next time, the Fed can do enough to save the day without also creating massive collateral damage?

If we continue to allow banks to grow, as they have over the last 30 years – and did again through the latest boom-bailout-rescue cycle – we head towards a day when Mr. Geithner or his successor will try to save the financial system and will fail.

You might think that is a good thing and for sure it will bring on a big change in creditor attitudes and presumably much stronger regulation. But, just as in the 1930s, first we will have to dig out from under a lot of economic rubble – and we’ll lose a lot more than 8 million jobs.


  1. My concern is that in the US and the UK, the too big to fail banks are now even bigger, yet still very weak. When the financial crisis started the comparisons to previous banking crises was to compare it to either Japan or Sweden. The decision to follow the Japanese rather than Swedish model was political. Down to the fact that the failed banks would have to be nationalised. Years of propaganda against state control, pushed both the UK and US towards the far more expensive but politically palatable Japanese solution.

    The banks have not been curtailed in any respect. With the changes to accounting rules they act as if they are even strong. They are even speculating to a greater extent in an attempt to rebuild their capital. The problem is that when they implode, as they surely will, the banks will be even bigger, and the the government even weaker, from trying to sustain the economy from the current crisis. There is no evidence that they are substantially reducing overall risk. They are truly becoming too big to save.

    When I look at the Japanese "lost decade" I see the problem as the write offs that the banks needed were not allowed to happen. So property drifted down in price for nearly two decades. All the time dragging down the economy. No matter how much the Japanese government spent they were unable to get the economy to grow. They were aided in two ways by the fact that Japan was still able to export to its customers, and that it could rely on the domestic savings of the Japanese to bail them out. The US and UK do not have either advantage. Both enter this crisis with the rest of the world in trouble as well. They also have trade deficits, and both are dependent on foreign savers. This is not a good combination. Long term they need to rebuild their domestic savings, and improve their exports.

    With low interest rates, the domestic incentive to save, falls. Also those saving for a future income via pensions or 401k are having to save even more to offset the lower returns, compounding the Paradox of Thrift. The low rates also do not help companies wanting to borrow. The banks have raised their margins to rebuild their capital base, and are not lending to customers anyway, because the banks and customers have become risk averse. While the Treasury are doing everything to deter the public from saving. This has created the worst of all possible scenarios. It preserves the asset values of those holding assets. It overvalues the assets for those wanting to buy. Just like in Japan. Leading to a long slow inevitable decline of asset values to a true value. Spreading the pain rather than inflicting it on those that speculated.

    Governments have seen the outcome of the Depression and are doing everything to avoid repeating the same mistakes. Yet they do just that, and make other new mistakes. They are withdrawing the stimulus too early again. They are not reforming the financial sector to prevent further crises. They have also signalled their path giving speculators a chance to play the system and thereby reducing the effect of any stimulus or action. They have also failed to let the markets reach their floor fearing the impact on banks and customers alike. All they are doing is delaying the inevitable. So I still fear a great depression this time pushed into the future and another election cycle when it is someone else's problem.

  2. I have been reading John Kenneth Galbraith and some of the earlier institutionalists. The case they make sounds better and better, in particular, JKG's suggestion that the defining contest is that between the people and the corporate oligopoly through the state, or for the state.