Image by Getty Images via DaylifeJohnson spoke quite emphatically about the need for fundamental financial reform, not as a partisan of any stripe (indeed, he claims to be a free-marketer more than anything else) but because the current financial system we have is not actually "capitalism" per se. Why is that? Well the phrase "too big to fail" (TBTF) signifies the problem at the center of our financial crisis, and within TBTF lies the potentiality for a future crisis even larger than the current one.
First of all, what is "too big to fail"? While we've certainly all heard the term bandied about since September 2008, I imagine there is some confusion out there. The concept is that the financial institutions that were bailed out through the Troubled Assets Relief Program (TARP) instituted by former Treasury Secretary Hank Paulson, Federal Reserve Chair Ben Bernanke, and President Bush, among others, simply held too many assets in our economy, and were too interconnected, to be allowed to declare bankruptcy. If the financial institutions (banks, such as Bank of America, and investment houses, such as Goldman Sachs) were allowed to fail, as Lehman Brothers was, then those failures would lead to an unprecedented breakdown of the global financial markets. Furthermore, due to the interconnectedness of the various players in the markets, the thinking goes, the failure of one of the financial institutions could lead to the failure of others. Why the institutions were all so interconnected is perhaps beyond the scope of what I'd like to say here today (in interests of length), but suffice it to say that AIG is one of the primary sources of the interconnectedness, and Goldman Sachs is another.
How did we get to this point where the banks were so big and interconnected that they could not fail without bringing down the global economy? Well, I could try to explain, but I think I'll let Prof. Johnson explain, with the help of Steven Colbert:
| The Colbert Report | Mon - Thurs 11:30pm / 10:30c | |||
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Prof. Johnson raises a few points that are worth elucidating in that segment; first of all, the idea that the TBTF banks have an incentive to act recklessly and to take foolish risks with their investors' money. This concept is known in economics terms as "moral hazard," and is essentially the idea that if you have a guarantee that the risks you face have been either eliminated or severely reduced by another party, then you will be inclined to take larger risks than you would without that guarantee. Take, for instance, driving a car without auto insurance versus driving with auto insurance; you're likely to drive far more slowly and carefully without insurance than you would with insurance, because with your insurer's guarantee that they'll pick up any financial losses you incur through poor driving, you are not "on the hook" for your mistakes in the same way you would be without insurance.
The implicit backing of the government that came with the TARP bailouts of the largest financial sector players creates a moral hazard scenario in just the same way. If a TBTF investment firm received a government bailout, then the individual managers and employees at that firm will be liable to take risks that they would not otherwise, as whatever they do, the government will ensure that their poor decisions don't cause the firm to go bust. So, far from reducing the incentives of financial firms to reduce their exposure to risky investments, the bailouts in fact increased the incentives of firms to take massive risks, and to leave taxpayers to foot the bill.
A second point to discuss that is a corollary to the first (and which Johnson spoke at length about last night) is that the TBTF firms, with their implicit government backing, are receiving preferential treatment in the financial markets that are creating advantages for the banks to become even larger. Essentially, because the government will not allow the TBTF firms to fail, they receive reduced interest rates when borrowing from private lenders. Because the lenders perceive the TBTF firms as "safer" investments than firms that don't have government backing, they are willing to reduce the interest rates they charge the TBTF firms compared to other firms. Naturally, this situation distorts the market's functioning, and gives the TBTF firms an advantage over their competitors that allows them to gain even larger market shares. Hence, the failure of capitalism due to government intervention in the marketplace. Johnson estimated the interest rates of the TBTF firms were reduced by approximately .7-.9% compared to their non-TBTF competitors, which may not sound like much, but when applied to loans and trades of billions of dollars at a time, those fractions of percents add up to large sums of money.
So what is Prof. Johnson's solution? To break up the TBTF firms into smaller, more manageable (and less economically dangerous) firms. Johnson and a number of other significant economists estimate that a $100 billion limit on total assets under a firm's control is an ideal target to aim for. What does that figure mean? Well the current combined holdings of Bank of America, JP Morgan Chase, Citigroup, and Wells Fargo are approximately $7.4 trillion, and there are 23 institutions in the US that have assets over $100 billion. Therefore, there will have to be a lot of division of these large institutions into smaller ones (simple arithmetic reveals that the $7.4 trillion of the four megabanks noted above, if divided into $100 billion sub-banks, would create 74 new institutions) and it is in the process of "breaking up" the banks that a lot of complication will occur, as in any complex transaction. Furthermore, these firms are all multi-national, meaning that the US acting alone will not achieve any significant regulatory reforms unless those reforms are accompanied by international agreements. It will be difficult enough for Congress to pass any semblance of meaningful financial reform (as evidenced by the Republicans' continued obstinacy) without having to deal with cross-border issues as well.
I think I'll stop there for now. There is still lots more to discuss about the financial crisis, as my understanding of the causes and the (proposed) solutions has been growing and evolving rapidly in recent months, and I'm eager to share what I've gained with you, my readers. Despite not being a "finance guy" in the least, I believe that the simple fact that our financial sector has become such an integral part of the world economy requires that I attempt to understand what happened and how to prevent a recession of similar scale from ever happening again. Any understanding I gain I'll attempt to pass on, since it's such a complex topic, but worthy of understanding by many.
In this posting I've focused only on the TBTF firms and the threats they pose to the financial markets and the world economy. In future postings, I'll look at the political implications of such concentrations of wealth and power, as well as how it is that the financial sector got to have such power and influence as it does today. If you have any further questions or a need for clarifications (or if I've totally bungled some facts in this posting) please comment on this piece below, or email me at generationalnavelgazing -at- gmail dot com (trying to protect my account from spammers, you know).
Additional programming note: I plan on returning to the subject of the Tea Party movement soon in an additional posting following up on my post from two weeks ago, so stay tuned for that.
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