Marty Moss-Coane of WHYY's "Radio Times" interviews economist Simon Johnson on the anniversary of the collapse of Lehman Brothers. Johnson believes we're about to enter the boom-bust cycle once again and that President Obama isn't at this time doing what needs to be done to curb Wall Street's excesses.
MMC: On September 14th, President Obama gave a speech at Federal Hall on Wall Street one year after the collapse of the investment bank, Lehman Bros. He warned financial executives not to return to their risky and irresponsible behaviors which led to a world-wide crisis. He reminded them that the government -- taxpayers -- had come to their rescue and may not do it again. Obama also called for more stringent regulation of the financial system. According to news accounts, the audience was not enthusiastic about the president's speech. They applauded just once and otherwise looked as though they wanted to get the heck out of there! So what did we learn in the last year and what are the prospects for meaningful oversight and regulation. To put it another way, are we headed for another financial meltdown?
Simon Johnson is a professor at MIT's Sloan School of Management. He's a senior fellow at the Peterson Institute for International Economics. He was the International Monetary Fund's chief economist and director of its research department.
Simon Johnson, how close were we a year ago to a complete financial meltdown?
Simon Johnson: Well, we had a complete financial meltdown! The credit markets froze. In the week to ten days after the collapse of Lehman, it was very hard for anyone to borrow on any terms almost anywhere in the world. Actually, that is a financial meltdown. We averted some of the worst consequences if that kind of meltdown -- I think through some heroic actions on the part of the Federal Reserve. A massive financial fire was put out and prevented from spreading as widely as it might have through the economy. There's no question we had a meltdown and the damage from that was enormous.
MMC: We're seeing, though, the stock market beginning to inch its way up. It seems to have stabilized a bit. Some are saying that because we didn't have a sustained total collapse that means the system has been fixed. What do you say in response to that?
SJ: [laughing] Well, it's obviously not fixed! I don't think anyone really believes that. President Obama didn't say that on Monday. Actually, his speech was very good at one level. It was very disappointing at another level. But at the level of diagnosis -- at the level of saying, "It's basically a problem of the structure and organization of incentives on Wall Street" -- he absolutely hit the nail on the head. Then he said, "It's not fixed yet," and asked them to please behave nicely going forward -- which of course they're not going to do if left to their own devices! He also outlined his own regulatory program. That's the disappointing part. Those proposals are anemic and weak.
MMC: I do want to get to that, but in terms of the response to the president, are you saying that the president doesn't have the kind of clout to get the financial world to behave instead of taking these risks? Risk not just to the US economy but risk to economies around the world?
SJ: Well, Marty... I don't want to sound exaggerated or outraged or anything! But let me point out that the Wall Street Journal reported the next day that not a single chief executive officer -- not a single CEO of any major US bank -- attended the president's speech. Okay, so every one of them was too busy to come and year him speak? That's incredible, right? That by itself absolutely encapsulates the arrogance of this industry. They're not grateful. They're not sorry. They don't even want to acknowledge that they messed up on a major scale. And the president -- and the president's men and women -- saved their rear ends, their companies, their jobs, their salaries, their bonuses, their pensions, their everything! It was done on amazingly generous terms. I think excessively generous terms. They can't even show up and applaud politely? Extraordinary!
MMC: But when the president said that if this happens again we may not be able to come to their rescue, do you think they believe him?
SJ: No, of course not! The key words there are "may not." The point is that if you run the Fed or the US Treasury and the big financial players as currently constructed are coming to see you on a Monday or late on a Sunday afternoon, and they say, "You know, if you don't give us a big bailout we're going to collapse and the world' banking system will come down with us," and you look them in the eye -- maybe they're bluffing, maybe they're not, maybe they know what will happen, maybe they don't -- are you going to risk that? No, you're not! When you say that these banks are "too big to fail," what that means is in that conversation -- and this goes, of course, to the Oval Office -- the president has to decide. "Do I take the risk? Do I close down these guys who've clearly messed up, clearly behaved irresponsibly? Do I risk a second great depression? Just to make my point? Or do I bail them out?" The big players on Wall Street are very sophisticated, very cynical, very experienced. They know how to play this game! They'll even show up to the president's speech. It's a done deal, as far as they're concerned: next time there will be another bailout.
MMC: We're talking about -- in the last year -- mergers, so we're talking about in some cases banks that are bigger than ever!
SJ: Absolutely. Our biggest banks that were already apparently "too big to fail" have become bigger. They've acquired other banks and other pieces of the finance industry. The concentration of economic power in the banking sector has gone up. And -- get this! -- their political clout on capital hill and more broadly in Washington (where I work part of the week and where I spend a lot of time talking to people and following the nitty-gritty ins-and-outs of this). The political power of finance and of the biggest banks has actually gone up! Washington Post has had a series of articles documenting this in a very impressive way, with a lot of detail, and people like Jamie Diamond for example, who heads JP Morgan-Chase, says: "Oh yes, now we're focusing much more on our Washington strategy. It's absolutely critical to us as a big bank going forward." These guys know how to play the game! They pretty much own the town right now.
MMC: If Congress were to, in some ways, create legislation to make banks smaller, you're saying that the chances of that happening are perhaps nil?
SJ: First of all, the administration is not proposing that. They've never put that forward. Secondly, it's unlikely that Congress would take up such an idea and that it would get through the legislative process. And thirdly, it's rather unlikely that regulators -- if they had some discretion in the matter which they almost certainly would -- would enforce that. But that's the key thing. It's the size of your biggest financial players. So CIT Group, which is a substantial financial institution -- total assets earlier this year when they were in serious trouble -- about $80 billion. Eight zero. They came for a bailout saying, "If you don't help us out, small and medium business in America, to whom we lend, will collapse." Actually the Treasury -- to its credit and credit to the rest of the administration -- turned them down and said, "No, you go sort it out with your creditors." And that's what they've done and have gone through some sort of (what we'd call) bankruptcy process. That was 80. The banks we've had trouble with, the Lehmans, the Bear Stearns, and all those other guys, were $600 billion, $800 billion and up to $2 trillion in total assets. If we could take those $2 trillion banks and break them up, turn them into more banks of below $100 billion in assets, it wouldn't be a panacea but it would definitely help and move us in the right direction.
MMC: You have described the Federal Reserve as the world's greatest bailout machine. Obviously the Federal Reserve can print money and help some of these banks stay in business. But you're saying that because of the power of the Fed, they have created this moral hazard that encourages bad behavior. Describe how that works.
SJ: I think that in order to understand the Fed, the good side and the bad side of the Fed, you need to go back to the founding of the Federal Reserve. It was after the crisis of 1907. A lot of big, powerful bankers got together and said, "We need public money to support the banking system." Senator Aldrich of Rhode Island was the leader of that faction. But there was also pushback from what we might now call "Wilsonian Democrats." Louis Brandeis, was the person who nailed this one -- he wrote a fantastic series of articles that became a book called "Other People's Money And How the Bankers Use It." People like Brandeis said, "No, no. Hold on a minute. Bankers are already too powerful. You can't just give them public money to play with. You have to have sufficient public control over the institution you set up." So the Fed is a compromise [laughs] and sometimes compromised by this relationship between helping the private bankers, particularly when they get into trouble, particularly in a crisis -- and having enough public oversight. Some phases of Fed history -- like from the '40's, '50's, '60's, and '70's -- have actually gone quite well. When finance has been heavily regulated. But prior to 1935, it didn't go that well. We had a massive speculative frenzy in the '20's and then a big crash in the Great Depression. Since 1980, we've actually taken away a lot of the regulation that worked after World War II. We've gone back into this unregulated, deregulated -- "finance can do whatever it wants and the Fed will bail it out later" -- Greenspan philosophy in a nutshell. That is really, really dangerous. So the Fed is a bailout machine. If you combine it with a tightly regulated financial system, we can all live our lives pretty well with innovation and plenty of growth -- that's the post-World War II experience. If you let finance get out of its box and get deregulated, really bad things happen quite quickly. And they happen again and again.
MMC: So when the President called for more regulation, what is your critique?
SJ: Well [laughs], calling for more regulation is what I'm calling for. The question is, what's in the details? If you go through it point by point and dissect what the government is putting on the table, it's very weak. They're not proposing to break up the biggest banks -- nothing in there about that. They're proposing to increase the amount of capital in the banks as a cushion against losses. That's what the shareholders have to lose before everyone turns around, looks at the taxpayer, and says, "Okay, your turn to cough up some money!" The administration, by the way, won't tell you how much they're proposing to increase it. As far as we can ascertain -- those who follow it very closely and talk with people on the inside -- the increase will be very small. One of my colleagues is actually calling it "dinky"! The increase is so small that if it was any smaller you wouldn't be able to see it. If you go back and look at how our financial system operated back when it was deregulated -- back when there was a lot of risk -- it had a total amount of capital, two or three times what we allow our banks to have. What our banks have now made sense if the '50's and '60's when they were tightly regulated. It does not make sense anymore. But the Fed isn't saying that. The President isn't saying that. We're not taking on these big issues.
MMC: There is a call for something called the Consumer Financial Protection Agency that would protect consumers. As an idea, do you support that?
SJ: Absolutely. That is the one piece of the President's agenda that I think is right. I think it's been well-defined. I think it's a sensible proposal. It's with Congress now but the banking lobby is vehemently opposed to this. You can see a lot of the debate by looking at the contrast between how the banks are attacking -- fully, head-on, using all kinds of contributions and various other devices -- to prevent this agency which would protect consumers from coming into being. On the other hand, all these other regulatory proposals the Obama administration has made -- the banking industry has no problem with them. Has never had a problem with them! They were allowed in on the design with the administration. They didn't even particularly object to what the administration first put on the table. It tells you that's not pushing these banks at all significantly in the right direction.
MMC: This gets a little bit into the weeds, but it's important. Some are calling for a merger between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Where do you stand on that idea?
SJ: There's no question that we have too many regulators in the US. A lot of our problems are actually the different distinctions and distance between federal regulators and state regulators -- for example, in insurance. This is a huge issue. So I'm in favor of consolidating these regulators as much as possible. And -- what you talked about -- potentially merging the people who regulate securities and the people who regulate [laughs] ... securities -- of course makes sense! That is incredibly difficult to get through because they report to different committees in Congress. Those committees in Congress do not want to give up that jurisdiction and that authority. That is an incredible uphill slog. I... would like all of the above. That's actually my approach to reform. But you have to make some choices and I would go much more directly after the underlying structures: the size of the big banks, their capital, and (by the way) the revolving door between Washington and Wall Street. It is incredible! You can walk out of a failing or failed Wall Street bank on Friday and on Monday be in charge of the program for bailing out those banks. When the US sees that in other countries, we're very, very critical of that. Yet that's our current situation.
MMC: I heard something recently on NPR. Someone had saved a tape of Bernie Madoff talking, I believe, to some potential investors in his company about the SEC and what to do about regulators. He was bragging about how you can hoodwink them and trick them into not knowing what it is that's going on in your investment company. Do you think he's unusual? Obviously, he sits in prison for this ponzi scheme. Does he represent an anomaly within the financial system or business as usual?
SJ: I think he represents a relatively unsophisticated player, actually. The other big people in finance are much more clever about how they run their schemes. I guess they do share the ability to outfox -- and stay ahead of -- the SEC. But there's a question about how hard the SEC has been trying, particularly in later years. A lot of the regulators, a lot of the people in Washington, really believe that what's good for Wall Street was good for the country. And of course that turns out to be sadly and almost completely wrong.
MMC: We're learning this week that the median income in the country has dropped about $2,000 from the year 2007 and 2008. The median income for a typical American family is close to $50,000. That's not a lot of money to raise a family on.
SJ: Absolutely. The people with a median income have not done well over the past 12 years, obviously. Inequality has got worse. That's not all. I guess it turns out that a lot of what we thought was growth in the early 2000's was not really growth. It was growth at the cost of these massive risks that we'd have to pay for later. Who pays for this? It's people who pay taxes. It's people in the middle of income distribution -- that's a lot of where the income tax burden and the [inaudible] tax burden falls. This is a disastrous outcome for most people in the middle class.
MMC: So is Wall Street just entirely disconnected from the rest of the economy?
SJ: Yes. There are some connections, definitely. I'm not anti-finance. I'm a professor of entrepreneurship at MIT. And I'm very much in favor of being able to raise capital, take risks, and fund non-financial innovation. I think venture capital, for example, is absolutely crucial. It's a big part of how this economy moves forward. But the financial sector, as currently constructed and operating around Wall Street, has become problematic. The costs vastly outweigh the benefits of the way they operate. Most of what they call "financial innovation" is not just not useful to the rest of society, it's extremely dangerous. They've taken these massive risks -- which maybe they understand and maybe they don't. Doesn't matter. When it fails -- and it's designed to fail in an important sense -- they come to the taxpayer and ask for money and it's blackmail, of course, at that stage. Jamie Diamond said this in a speech earlier this year when he said, "Well, you know, you can let us fail, you can vilify us, you can say it's all our fault. But then you'll have an even bigger recession. Your choice! What do you want to do?" And, of course, that's how they get off the hook.
MMC: But are you saying that Wall Street is essentially back to its bad old ways? Before the bailout and the implosion last fall?
SJ: Oh yes, absolutely. I think in some ways we're in worse shape than that. Now I'm not saying that we're going to have another crisis immediately. Back to back, severe financial crises are very rare. Instead, of course, you go through another cycle where people feel good and the major players take on a lot of risk. Of course, they'll have a good run for a while. They'll pay themselves massive bonuses. When there's an upside, they get the upside. When the downside comes -- 2? 3? 5? 7? maybe 12? years down the road -- it's huge. Look back over the last 20 years. think about Alan Greenspan's achievement as governor of the central bank, as chairman of the Federal Reserve in this country. In 2001-2005, people said he's the greatest central banker we've ever had. Now you look back and say, "I don't think so. I think he was actually a disaster." What happened over the past 20 years. He was probably the worst central banker this country has ever experienced.
MMC: What do you say about Ben Bernanke so far?
SJ: [laughs] Ben Bernanke has done a very good job as a fire fighter. Once the financial fire broke out and once the meltdown occurred, he worked really hard to prevent that from spreading and from becoming even more damaging. But of course fire fighters have two jobs, really. One is fighting the fires when they break out. The other is trying to prevent fires, trying to think ahead, trying to design systems and strategies that make fires less likely -- and less damaging when they break out. And on that one, I'm afraid his track record is not so good! When he worked at the Fed under Alan Greenspan, he was absolutely in line with the Greenspan idea that you don't worry about bubbles or financial frenzies when they're building up, you just clean up afterwards. That's what we just done, the last 12 months. You really don't want to do that and you really don't want to do what we've been doing the past 12 months again. More importantly and more relevantly, in terms of what he's saying now about what he's planning to do... you know, he's been giving speeches -- he gave a speech at the Brookings Institution in Washington and he laid out his view of what the problem is and what reform [inaudible] is, and so on. It's all very technocratic, all very hollow-sounding. And it is hollow. He's not confronting or even speaking about the deeper, underlying political realities here and the power of the financial sector and how it's going out of control. Now, not all of that is up to him to fix. But his intellectual leadership of the Fed is absolutely critical, for good or ill. ... [inaudible... note: Johnson speaks very fast, and occasionally words get lost]
MMC: So if you ran the Fed -- perhaps we're hearing what you would do if you ran the Fed! -- what would you do?
SJ: I think that the task that we're facing -- specifically the chairman of the Fed needs to take on the diagnosis and definition of the problem in much more stark terms. And explain to people -- some of which you can do in public, some of which the chairman of the Fed can't say in public but can push for very hard in various private contexts on Capitol Hill, with the administration, and with the industry. You have to push for the true end of this too-big-to-fail syndrome. And having these little technocratic tweaks such as "We'll have a Resolution Authority that will give us the legal power to deal with these banks" (that's what the administration wants to do and what Bernanke's supporting at the moment -- it's just not convincing. Because when these big guys come to you and they're across borders, for example -- CitiGroup is a massive global bank -- and if they were, hypothetically, to come to you and say, "We're about to fail," this Resolution Authority that they're putting all this weight on doesn't deal with cross-border issues. So even on their own, narrowly defined, terms the solution they are seeking does not address the problems they faced last fall. How can this make sense? The Fed has to do things very differently.
MMC: I'm looking at something you wrote at your website, Baseline Scenario.com. In part we've been talking about this. You're saying, "Financial institutions have to be made smaller. They have to have more 'skin in the game.' You have to address the revolving door between Wall Street and Washington." The Fed has to rethink it's ability to be this bailout machine. Is that what you're calling for?
SJ: Yes, absolutely. None of that is stuff the Fed feels comfortable calling for -- the existing Fed chair or Fed structures. And that's kind of the point. We've designed a system in which the guys in charge of the bailout, the guys who really know how the thing went wrong and what you need to do to fix it -- I think they do understand this -- feel constrained. They feel it's not their job to talk about it.... and so on. That's a problem. That's not okay, as far as I'm concerned.
MMC: But it sounds like fixing this revolving door between Wall Street and Washington is the top priority, then?
SJ: I think that's huge, to be honest. I think there's a very clear conflict of interest where people go either from Wall Street to Washington or when they go from a key regulatory position in Washington to Wall Street the next day. Or to an advisory position on Wall Street. I think there should be a five-year moratorium on that. I think people will be shocked, they really don't like that proposal. But I'm afraid we've sunk so low that you have to swing to the other extreme now. You cannot have people going back and forth and people in government thinking, "Aha! I'm going to land very nicely at Goldman Sachs after I'm done with this government gig." Of course that leads to perverse and crazy incentives. And by the way, when you see this kind of thing happening in another country -- when we saw it in Indonesia, for example, in the fall of 1997, when the US Treasury was controlled by Robert Rubin, Larry Summers, and Tim Geithner was also working there -- the US was very hard on Indonesia. Very critical. And directly and through the US position at the IMF, they put a lot of pressure on the Indonesian government which after -- perhaps -- some unintended consequences led to the fall of of President Soeharto.
MMC: Hmm! Have you been asked to testify before Congress? Curious...
SJ: [laughs] Yes, I've testified to quite a few committees of both the House and Senate, and the Joint Economic Committee, over the past nine months or so.
MMC: And the reaction you got, was it kind of like what the president got at Federal Hall with those financial titans sitting in the audience?
SJ: No, no. Actually the response on Capitol Hill is pretty good at the level of "we have a huge problem in our financial system and we should fix it." I think over time it's become more polarized and more partisan -- which to my mind may be actually fairly productive -- with the Democrats saying how we have to regulate properly and more. There's always a range of opinion on the Democratic side. On the Republican side, you have a lot of people saying, "No, no, the problem is regulation. We should deregulate more!" Right? So I'm more in the regulating camp, as you might guess. But that's at the level of testimony, that's at the level of these sessions I'm involved in which are more about the economics and economic incentives and policies going forward. The problem is that when you get into the nitty-gritty of designing legislation that the special interests come into play. It's interesting. I've never been called to testify on a panel, sitting next to a banker for example. I think that would be quite interesting! And, at the height of the crisis and subsequently, various people have tried to arrange debates between me and (say) the American Bankers Association. Or the roundtable that represents big finance. And they don't want to talk in public. They work very effectively in private. They work behind closed doors. They have lots of leverage, I guess! [laughs] And they're very good at blocking in the trenches what otherwise should happen.
MMC: ... We have a call from Vincent from Philadelphia to join our conversation.
Vincent: Just to support what you said, Niall Ferguson, the Harvard and Oxford professor and a good friend of [Professor] Johnson's, I'm sure, points out in a current issue of Newsweek that the 10 largest financial institutions rose from 10% to 50%. In other words, 10 banks control 50% of the financial assets in America today. Boy, if that's not "too big to fail" I don't know what is! But anyway, there was an earth-shaking judicial ruling coming out of Judge Rakoff's office yesterday and it's been all over the financial media. He won't accept Bank America's settlement -- the SEC settlement of $33 million -- which is ridiculous. He's going to have them go to trial and has got Congress swinging into action. I hope Professor Johnson will be invited before the Oversight Committee chairman Edolphus Towns and I hope you [MMC] get Congressman Kucinich on because both of them have just send Mary Shapiro, SEC chairperson, a letter. She's been presiding over that agreement. Professor Johnson is right on target...
SJ: I thought that was a terrific ruling. I don't know if it will stand up under appeal. But what the judge said was absolutely brilliant because there's $30 million or so settlement that the SEC had agreed to. Basically, that's a fine on Bank of America and its shareholders for Bank of America misleading its shareholders. Which is crazy. And the judge said, "This is crazy! I want to see the issue of the responsibility of Bank America executives -- the individuals, the people -- I want to see that on the table. You could presumably do that through a revised settlement or through a trial. I think he's absolutely right. We've got to the point where the people -- individuals running our banks -- are not held responsible for their actions. And that has to stop.
MMC: We have a call from Dale in Kennett Square.
Dale: It was Republican Teddy Roosevelt that made the case that some companies were so big that they were too big to fail and they were a threat to democracy. Having said that, the matter of personal accountability comes in. Why is it okay to kill people in death penalty cases but it's unthinkable to put a business out of business -- have a death penalty for businesses? In Pennsylvania they took the charters away from ten or twelve banks in the 1800's because they did egregrious harm.
MMC: ... Imagine if Lehmann Brothers or, let's say, AIG had been allowed to fail. What do you think the impact would have been?
SJ: At the moment when the government faced that problem last fall -- once you get to that point, allowing these big guys to fail can have potentially catastrophic consequences. That's the point. That's what they designed these structures. That's what give them this blackmail-in-a-crisis power! But I'd like to what the caller said ... two dimensions I thought he had exactly right. Teddy Roosevelt is exactly the right historical parallel here. Teddy Roosevelt stood up to the big financial industry interests of his day. He had a big showdown with J.P. Morgan, for example. Teddy Roosevelt said (and felt very strongly) that the industrial trusts which were finance-backed -- but they manifested more as railroad trusts, for example -- had become too powerful politically. They challenged the executive power of the US. Andrew Jackson had the same showdown in the 1830's, by the way, with the Second Bank of the US. FDR had to face down the securities industry in the 1930's. This is a repeated cycle in American history. As for the caller's point that why don't we have the death penalty for businesses: the US is very, very good at shutting down small and medium-sized banks. The FDIC's resolution and [inaudible] process first class, okay? What we cannot handle is the top ten, thirteen, fifteen banks. That's where we choke right now. That's what has to be fixed. The only way to fix them is to do the Teddy Roosevelt strategy: break 'em up.
MMC: An FDIC for these big banks? Is that what you envision?
SJ: Well, the FDIC for these big banks has been proposed. Some people are kicking that around. ... But if you think in those terms -- FDIC as an insurance arrangement -- they would have to charge, for this to really work, an insurance premium that is appropriate for the risks being taken by these massive banks. Well, you've seen how big the risks are. You seen all the resources -- Federal Reserve resources, taxpayer resources -- that have to be committed when these things fail. A properly priced insurance premium would be prohibitive. The large banks wouldn't be able to exist -- which is fine with me! That'll press them to be broken up. But realistically, they'd just pay a lower premium than they would otherwise. And you'd basically be carrying the existing arrangement which is an implicit form of taxpayer guarantee that ends up being incredibly expensive and doesn't prevent them from taking on these relentless risks that we all come to regret.
MMC: One description I've heard of our system is that you get unfettered capitalism on the way up and socialism on the way down when the government intervenes!
SJ: Some people like to call it "lemon socialism." Meaning, you only get the lemons, you only get the bad stuff! The Wall Street expression is: "Wall Street gets the upside and the taxpayer owns the downside." In a sense what we're seeing here is a repeat of what Wall Street's seen before. But it's happening now on a scale that was never previously imaginable. The financial sector in this country used to be 1-2% of GDP back 50-100 years ago. It was 4-5% of our economy after World War II. Since 1980 it's 8%. 8% of all we produce in this country is financial services and these turn out to be very dangerous.
MMC: I want to talk about executive compensation, something that you and many others have talked about and certainly something that rankles most of the the public. When you look at compensation for financial executives, is it just that they get paid so much or that somehow their pay is not connected the performance of their company?
SJ: Well, the pay is obviously connected to the performance of their company when things go well and when they do great. When things go badly, they don't lose. And this is a big change from, say, the 19th century. In the 19th century when you managed a bank that failed you lost your money -- because most of your wealth was in that back -- and you lost your social position. You were not re-employed in the government or another major bank! Some how we've moved away from that. The culture of executive compensation, very broadly defined, is "make out like a bandit in the boom and when things go wrong, walk way with a golden parachute or a lot of cash." Or maybe you lose the value of shares. But still, you go from being a billionaire to being a multi-millionaire. That is definitely part of the problem here. Executives are not being careful enough because they don't have enough skin in the game.
MMC: How would you get more skin in the game, to use your phrase?
SJ: I think the key is to make their compensation contingent on they're not being a major failure. Of course the trick there is that these failures are not manifested within 12 or 24 months but over a much longer period of time -- 5 or 10 years, for example. So there has to be a lockup and a hold on the wealth that they acquire from these activities for a long period of time. The debate is nowhere near even recognizing that principle. But if it were up to me, I think at least a 10-year hold would be appropriate.
MMC: And give shareholders more control, more say over executive pay?
SJ: That certainly would be constructive. But I would also stress that shareholders need to have more equity, more commitment. The amount of capital that banks had at risk before 1935 was roughly two or three times what they have now. In fact, under the National Banking Act of 1863, if the bank failed you, the shareholder, were liable not just for the money you had in the company and could lose but for another hit equal to the par value of those shares. This was contingent liability or contingent capital that bank shareholders had to put it. As a result and as you can imagine, bank shareholders were a lot more careful about who was managing the bank and what they were doing because they had more money at stake. If you let these banks operate with very thin cushions -- a little bit of equity and lots and lots of debt -- then, if it fails, you the shareholder don't mind that much. If they're a lot more capitalized you're going to be much more careful.
MMC: What about this board compensation committees that come up with these executive salaries?
SJ: Well, it's obviously cooked!
MMC: They're all part of the same club? They literally go to the same clubs and send their kids to the fancy private schools?
SJ: Yes. Rakesh Khurana at Harvard Business School has written a brilliant book and some other pieces on exactly this -- on how you construct this social reality and perspective, sort of cultural capital around boards and compensation. It's a huge problem for shareholders. These financial companies are run primarily for the insiders, primarily for the powerful insiders, and very little for the shareholders. It's a very, very tough problem. We should be working on that, too. While we're working on it, we need to break them up, make them smaller so at least in the meantime they're a little less dangerous.
MMC: You're saying it's a culture where it's not unusual for someone to make millions and millions of dollars so why wouldn't you give an executive some lovely golden parachute?
SJ: Absolutely. The whole thing is priced relative to what other execs are getting. They say, "Well, this guy down the road has got these incredibly generous terms. I should be getting this. Or I should be getting something a bit better." And the boards are not browbeaten. The boards are convinced. They believe. That's very important. A lot of this is about ideology. A lot of it's about shared believes and perspectives. It's a form of cultural capital and cultural capture by these powerful finance insiders. The likes of which you've never seen before in this country or actually anywhere else.
MMC: Jerry is calling from Haddon Heights.
Jerry: We'll have to go back to some of the financial regulations that were repealed. I was wondering if part of the prevention of the "too big to fail" scenario would be some sort of Glass-Steagall type of regulation. When they repealed all that, that's when all this nightmare started and these banks became 'way too big for their britches.
SJ: Jerry is right. The waves of repeal of financial restrictions around the time of Glass-Steagall were absolutely critical here. I would put more emphasis, perhaps, on some other things and particularly the failure to regulate derivatives at the end of the Clinton administration. Glass Steagall, of course, was the measure taken in the 1930's to address the problem in the 1920's that investment banks had become very much like commercial banks and were able to use some of the protections and activities of commercial banks to fund speculative investment activities. I'm not sure that in today's world that distinction has quite the same importance. Remember: the financial sector is innovative, they move one, and they found ways for pure commercial banks to do absolutely crazy things -- like lend subprime mortgages, like get involved 'way over their heads in derivatives -- while that remains commercial banking. And of course the investment banks did lots of crazy things as pure investment banks. They made themselves so big that just as investment banks they threatened the world's financial system and the world's economy. I'm sympathetic to this Glass Steagall line, but I think much more important, much more cutting to the modern chase, is making them smaller and having a lot more equity and reducing the Wall Street/Washington revolving door.
MMC: What would you do about derivatives?
SJ: Derivatives are a very interesting and tricky matter. Some people in the non-financial sector say they want to be able to hedge risks and they can do that with derivatives. But I think the consensus of opinion is putting all derivatives on exchanges and having them be much more regulated, much more transparent. Then of course there's this issue of to what extent you allow the financial firms to have risks which turn out to be hidden risks through their derivative positions. That's where you really have to clamp down. Again, if they're smaller, it doesn't matter as much if they take risks and fail. If you go to Las Vegas and lose all your money on whatever kinds of speculations -- derivatives, roulette, whatever! -- that doesn't matter too much to me. It's your money. It's sad but it doesn't endanger the economy. It's when you're very big and you lose money on wild, speculative gambles -- even if you're gambling on sensible instruments -- that's where we get our huge problem.
MMC: We have Michael from Unionville.
Michael: My question is about the credit rating agencies and what maybe we should have done about regulating them. What basically happened is that they were delivered bags of rotting offal, had their palms crossed with three pieces of silver, and stamped "USDA AAA Prime" on the stuff so it could be sold to the Fisherman's Bank of Norway or something! Seems to me that those rating agencies, where everybody is complicit in particularly the subprime issue -- is anything being done or should be done to control their activities and their methodology of risk assessment?
SJ: It's a great question and a very nice statement of the problem, actually! Very little is being done to arrest the problem of credit rating agencies. Clearly the underlying problem is that they're being paid by the guys underwriting the securities. They should be compensated in another way. They should be compensated by the people who buy securities. There's no agreement on how to do that and I don't think this is going to be where you'll see change. I think the credit rating agencies are a tool, an instrument in the hands of these big financial players. We should address the problem at its core, at the level of how much power the financial players have and how to make them smaller. I'm certainly in favor of finding ways to change the compensation schemes that fund the credit rating agencies and allowing more entry into that business and broadening the set of people who are allowed write ratings could also be helpful in that context.
MMC: We've got Robert now from Jersey City.
Robert: I'm just curious to know if you're familiar with the work of Dougless Rushkoff. He just came out with a book called "Life, Inc." where he talks about the corporate age being the cause of the economic crisis. Basically, this virtual economy which is predicated on the creation of debt not the creation of value which was the original foundation of our economy. I just wanted to know what your thought are on that or his work, if you're familiar with it.
SJ: I must admit I'm not familiar with it but I'll see if I can download it to my Kindle immediately after the show! I think on the point as to whether we've moved away from the creation of value to the creation of debt, that actually sounds right. Within the financial sector. I think it's very important that we have a strong, non-financial sector in this country. We're very good at innovating and creating things. I work at MIT. I'm not an innovator, not an engineer. But I've seen a lot of that over the last twenty-five years. I really appreciate it and have seen how that become companies and new products. On the non-financial side, we're the envy of the world. We have people lined up at the door at MIT wanting to understand that process of non-financial innovation. I think where we've gone wrong is that too many of us have bought into the idea that financial innovation is kind of like non-financial innovation. After all, the word "innovation" is really good, very positive connotation in modern American culture and with good reason. But financial innovation is not just like non-financial innovation. Much of recent (last 20-30 years) modern innovation has come with these hidden risks. And these hidden risks, when they materialize they materialize together and they're a very big hit on the taxpayer. That's very dangerous. It's totally unlike non-financial innovation.
MMC: But I wonder how you create an economy that encourages this kind of non-financial innovation that you just described?
SJ: I think we have. We had an economy that was very good at that in the 1940's through '70's.
MMC: How do you bring it back?
SJ: I think you put finance back in its box, to be honest. We had a highly regulated financial sector in that post-war period. It didn't prevent us from having big breakthroughs in technology. Think personal computers, think telecommunications. Actually, even within banking. The banks invented ATM's. We invented venture capital in and around the financial sector. And credit cards were also invented in that relatively regulated phase. So I just don't buy the idea that you need modern, unfettered, so-called "financial innovation" in order to have growth. It's done very little for us even in the most positive reading. And in my reading, which is not at all positive, it's led us into great and grave danger.
MMC: In fact, I'm looking at the New Republic, the September 23rd issue, and you and Peter Boone co-authored an article. The headline reads, "The Next Financial Crisis: It's coming and we just made it worse." Are we on the cusp of another financial crisis?
SJ: Yes... but let's be careful. Remember, back-to-back crises are not the norm. The norm -- what we've seen in the last 20-30 years in this country and other places where finance gets out of control -- is you have a boom-bust cycle. The boom can last for a while. I think in a year's time you might look back on this conversation and say, "Well, Simon was exaggerating. We haven't had a crisis." I'm not saying we're going to have a crisis in the next twelve months. I'm saying we're building up the same kind of vulnerability that we had in 2003, 2004, 2005. And of course it kept going unti 2007. In fact, a lot of it kept going until 2008, right? And people felt good. People said, "Well... all this is acceptable, all this is fine, and if there's a problem we'll clean up later." And then we have a huge crisis and when you reassess the previous decade -- I'd say the previous two decades of Alan Greenspan's tenure at the Fed -- and you say, "Oh My Goodness! We were just deceiving ourselves. That was illusory. That was ripping off people." A lot of financial people walked off with much cash but the rest of us got absolutely hammered by this experience. So we're on the cusp in that sense.
MMC: It sounds like you're saying, looking at the past, that we're only able to diagnose our problem in hindsight? I ask that because I'm curious, as you look ahead -- and perhaps it is signs of a boom and then of course the bust follows the boom, what you will be looking for to indicate that uh-oh, here we go again!
SJ: I think you look no further than the attitudes and behaviors of the financial sector. As I said at the beginning, the fact that no bank CEO's came to listen to President Obama when he was asking them very politely to please behave better in the future -- with or without regulatory reform -- I think that tells you a lot. I think the financial sector has its swagger back. The swagger is good for them and very bad for the rest of us. That is what we've learned the hard way over the past few years. If you go back and look at the last years and the way the Fed has operated and where the Fed has been a positive force in the American economy and when it's actually not been a positive force but reinforced these cycles, that's what we do in the New Republic article -- I think we say, "We need more financial regulation in a hurry!" If we're going to make an error here, perhaps we should err on the side of too much regulation for a while and put those guys much more in the box where they were in the '40s, '50's, '60's and '70's. And the rest -- the non-financial part -- of our economy based on that evidence and based on what we're seeing now more broadly would do just fine.
MMC: You've mentioned that both Roosevelts -- Teddy and Franklin -- stood up to the banks and the financial system. Are you saying that Obama needs to be tougher? I mean, he used some strong language but that he isn't tough enough with this part of our economy?
SJ: Yes, that's exactly what I'm saying. He should have been tougher on them back in March. He felt, for whatever reason, that was inappropriate. Now the economy is recovering. He should absolutely be tougher on them. He should be pushing them much harder. I think you can see from the fact that they don't even come to his speech that when you don't demonstrate strength -- when you try to accommodate them and try to be nice to them -- you don't get respect from Wall Street. Wall Street is about power. Wall Street is about looking at the odds, assessing the trade, and saying, "Yep. We know where this one is going! Thanks very much, President Obama. We've got this one and we're going to run the next cycle just like we ran the previous one."
Recent articles from and interviews with Simon Johnson
Atlantic, "The Quiet Coup: How bankers took power, and how they're impeding recovery."
On Point, Roundtable discussion on "Wall St., A Year After the Meltdown"
New Republic, with Peter Boone, "The Next Financial Crisis: It's coming--and we just made it worse."