Arnold Kling  

Baseline Scenario: The Book

Socrates Meets Deficit Neutral... Confusing Health Care and Heal...

Simon Johnson and James Kwak call it 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. It is one of the most valuable contributions to the literature on the financial crisis.

Of all the economists, journalists, and pundits who have written on the financial crisis, Johnson and Kwak are the ones who most strongly emphasize the political dimension of financial regulation. They see large financial institutions as capable of creating a political juggernaut. Hence, their main policy proposal is to break up large banks. As you know, I have been brought around to their point of view, which has been articulated on their blog.

Johnson and Kwak start by putting the issue of large banks in historical and international context. Although they lean left, they may shock progressives with their sympathetic treatment of Thomas Jefferson and Andrew Jackson in their suspicion of financial concentration.

Johnson and Kwak even depart from the usual progressive narrative in which the Federal Reserve was the creation of forward-thinking experts seeking to modernize the U.S. financial system. Instead, they tell more of a bootleggers and baptists story. p. 27:

Nelson Aldrich represented the viewpoint of the banking industry...Aldrich was the chair of the National Monetary Commission...which recommended the creation of a central banking system largely controlled by the private bankers themselves...What these bankers wanted was a bailout mechanism that would protect the financial system in the event of a speculative crash...They knew that a new central bank would need the political backing and financial support of the federal government, but at the same time they wanted to minimize government interference, oversight, or control.

The next chapter looks at the political economy of banking from an international perspective. Johnson's experience with the International Monetary Fund acquainted him with political-financial oligarchy as it has evolved in many other countries, particularly those in emerging markets. This provides him a lens through which to view our recent experience. He sees a "this time is different" level of complacency among U.S. policy makers. The mindset is described on p. 55:

Two of the crucial ingredients--tight connections between economic and political elites and dependence on fickle short-term flows of foreign capital--seemed completely out of the picture...In countries that had already "emerged," like the United States, economic questions could be studied without reference to politics. Instead, economic and financial policy presented only technocratic questions...

Next, Johnson and Kwak offer chapters that tell the story of the growth and concentration of finance in the United States from the 1980's until today. p. 59-60:

most of the growth in the financial sector was due to the increasing "financialization" of the economy--the transformation of one dollar of lending to the real economy into many dollars of financial transactions. In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the real economy; by 2007, that had grown to $51.

Again, they tell a story that intertwines politics with economics. They view deregulation as a development that (p.64-65)

emerged from a confluence of factors: exogenous events, such as the high inflation of the 1970s; the emergence of academic finance; and the broader deregulatory trend begun in the administration of Jimmy Carter but transformed into a crusade by Ronald Reagan. The eventual result was an out-of-balance financial system that still enjoyed the backing of the federal government...without the regulatory oversight necessary to prevent excessive risk-taking.

Among the exogenous events, I would include the computer revolution. The ever-increasing power and ever-decreasing cost of computers made financial transactions cheaper and made possible more complex financial instruments and more sophisticated risk-management techniques. Only with hindsight is it possible to sort out the uses of computers that provided genuine gains in efficiency from those that produced self-deception and overconfidence.

Johnson and Kwak reconstruct the dominant point of view in the regulatory community, which amounted to complacency and cheerleading for innovation. p. 103

At an August 2005 symposium...Raghuram Rajan presented a paper asking in prophetic detail whether deregulation and innovation had increased rather than decreased risk...Fed vice chair Donald Kohn responded..."As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market."

Jumping ahead to their concluding chapter and policy recommendations, p. 219:

A real cap on bank size will not only level the economic playing field and reduce the incentive for banks to take excess risks predicated on the government safety net, but it will also weaken the political power of the big banks...Without a privileged inner core of thirteen (or fewer) bankers, the financial sector will be composed of thousands of small companies and dozens or hundreds of medium-to-large companies...The financial lobby will continue to be strong by virtue of its sheer size...But the distortion of the playing field in favor of a small number of megabanks will come to an end.

Let me finish this review with a few quibbles.

1. I think the authors over-emphasize ideology and under-emphasize exogenous factors in their story of how the 1930's regulatory structure broke down. Although they mention inflation, they do not spell out exactly how the 1970's inflation forced changes to the financial system and produced the savings and loan crisis. Nor do they make clear that the growth in securitization in turn emerged largely as a policy-driven response to the savings and loan crisis. It may be too easy for readers to ignore the occasional doubts that Johnson and Kwak express about regulatory technocrats and to dismiss the recommendation to break up big banks as needlessly radical. Instead, a reader with a predisposition to favor progressive government could conclude from the book that the solution is simply to insulate regulators from free-market ideology.

2. In my view, the authors make too big a deal of the issue of over-the-counter derivatives. Suppose that the advocates of regulation had gotten their way in 2000. My conjecture is that we still would have had a housing bubble and a financial crisis. The hypothetical regulated-derivatives world would have been little different from, and not even necessarily better than, the actual world.

3. I was confused on p. 125, where it seemed that Johnson and Kwak viewed J.P. Morgan's BISTRO as the progenitor of the credit default swap. I thought that BISTRO was the progenitor of the tiered collateralized debt obligation, in which default risk was layered into various tranches so that that top tranches could get AAA ratings. I may be wrong about either the financial history or about my interpretation of what Johnson and Kwak are saying.

COMMENTS (9 to date)
Alex J. writes:

BISTRO: Bank for International Settlements - Total Rip Off

I think you're right about point 3.

Hunter writes:

Don't the large Canadian banks provide a counterfactual to the assertion that large banks create instabillity and that it's the regulation and not the size that is the difference.

Doc Merlin writes:

why would larger numbers of smaller banks be any better?
They can still lobby as a group organization just as effectively.

Arnold Kling writes:

Hunter, the Canadian banks are large relative to Canada, but they are much smaller than U.S. banks. I would be happy if no American financial institution were larger than the largest Canadian bank.

The lobbying by smaller bankers would be different. They would not be lobbying for "too big to fail." The lobbying for securitization would not be so powerful. Also, politicians and regulators are not as awestruck by industry lobbying groups as they are by executives at Goldman or Citigroup.

Grant writes:

Arnold: First of all, for the purposes of defining their effect on the stability of the financial system they are operating in judging banks only in terms of their size in an absolute scale instead of their size relative to that financial system is a little silly. The Big 6 Canadian banks control over 90% of all Canadian banking assets.

If we are going to look at just size in absolute terms, yes the Canadian banks are smaller than the largest American banks... considering they're primarily based in a country with 1/10th the population and size of economy of the US. But they're still organizations with hundreds of billions of dollars in assets and in *relative* terms they dwarf anything that exists in the US banking system. If the US had a bank that was of comparable size within it's system as, say, RBC is within the Canadian system, you would be looking at something several times the size of the largest US bank.

So the hypothesis that banks getting "too big" was the problem is less than compelling. It wasn't their size, it was how they conducted (and were permitted to conduct) their business.

Doc Merlin writes:

Thanks Arnold.
Makes sense about the awestruck-ness.

I disagree with the point you make about the "too big to fail" doesn't work, because much smaller institutions have been bailed out using similar arguments. What matters is the political connectedness of their stockholders and bondholders and management.

Also, I don't think banks were actually "too big to fail" or any such nonsense, neither was GM, or really anyone involved. GM (which is really a large bank and pension fund) made the exact same arguments, and then when it did go bankrupt, it didn't have much of an effect on the US.

Doc Merlin writes:

I forgot to add, farmers are very, very effective at getting subsidies and getting congress to enact legislation in their favor, and they aren't anywhere near as monolithic as the large banks in the US. So, I'm still not convinced breaking them up would help. Also, if they can be broken up, they can use that as a political weapon against each other. If bank A is doing really well and outcompeting the others, bank B and C can get together and get them broken up.

MernaMoose writes:

A real cap on bank size.....will also weaken the political power of the big banks...

Okay. But then tell me Arnold, why doesn't this apply to all segments of the economy, if it works for banks? What's special about banks compared to, say software?

I have very mixed feelings about the size corporations we should like to have. Nobody has put up arguments that cleanly persuade me one way or the other. Having lots of smaller companies holds the prospect of putting us closer to ideal market conditions (lots of suppliers and buyers all acting in the market place).

But then, how do you define "size" in a rational manner? In terms of both what makes for "big", and what makes for "optimal"? "Economies of scale" is not a figment of the imagination.

I'm the first in line to gripe about M$ software. I think they produce a lot of unnecessary garbage which, by any rational analysis, does positive economic harm to both the US and the global economy. But the fact that I can send a spreadsheet to anybody anywhere, and they can probably read it -- now that's worth something. Those of us who grew up on DOS prompts and VAX clusters are especially aware of this.

But my hesistation with allowing corporations to become "gigantic", however we define it, is that I believe you're right and they do come to wield too much political power. The power they gain is apparently subtle because almost no libertarian types seem to grok it (I'm surprised you seem to, at least to some degree).

Doc's point above is valid. Groups of small companies can form a lobby and get cartels or special favors set up. But over the span of my career I've worked in everything from a three person small business, to mid-sized, all the way up to mega corps with global arms of staggering proportions. There are distinct differences in management attitude as company size grows.

Small to mid sized firms will attempt to get special favors arranged for themselves. But at the same time, if the government attempts to impose some really stupid regulations on them, that would harm or even kill off their segment of the economy -- well, you know they're going to fight. And "lots of small companies" means "their name is Legion". The government cannot put them down with one fell swoop. These are the kind of people who will provide fertilizer for grass-roots PACs which will oppose government grabs at undue power -- just as readily as these same PACs will lobby for special favors.

You simply don't get the same level of opposition to government power grabs from big corporations. They're a different animal. You have to work inside one and rattle around the hallways for a few years, to believe it. Corporations really do breed armies of amoral managers, who rise through the ranks and eventually staff boards of directors.

Small to mid sized firms are intimately aware of how stupid regulations are going to impact their margins. Big corporations, however, are usually more diversified business creatures, and more able to take a given load of stupidity in stride. And their managers are just not invested in the business, the same way they would be in small to mid sized firms.

So I'll give just one example of what this leads to. Take affirmative action laws, which have been sweeping through the US corporate universe in recent years. The government goes to the BODs of the big mega corps and says "This is what we're going to make you do, you're going to promote incompetence way beyond its capacities, and you're even going to build a shrine to it". (read: restrict promotions especially for white males, who will be held to quite different standards than politically correct minorities who will be promoted to positions they aren't qualified for). The Board of Directors says "You want me to do what? Oh, well, okay, I guess we can do that."

And so it becomes law, with no real push-back. Because the big boys are willing to do it, and the small to mid sized firms at this point just don't have enough clout to fight it. Big corporations and government end up becoming more or less extensions of one and other. There'd be a whole lot more push-back if there were a whole lot more small to mid sized firms on the stage, instead of a few big fish managed by the "Oh, well, okay...." types.

Anyone who thinks this isn't going on today, doesn't work in a large corporation (or works in one of the few remaining hold-outs). And while some may say "this really doesn't matter in the big picture", some of us who work in places like the aerospace and automotive industries would beg to differ. We're watching affirmative action get imposed on design and manufacturing processes, where poeple's lives are at stake. What do you think happens when engineers screw up the design or fabrication of a car or airplane part, and it gets out the factory door?

And btw, is anyone aware of just how many other stupid things like affirmative action, have been imposed on US companies in recent years? Accelerated for real after 9/11. It's driven the cost of doing business up and cut into margins. Tell me that hasn't contributed to the current down turn.

Sorry if this is long but I believe there's an important issue here, and I think most libertarian types aren't tuned into it. Mega corps are essential enablers of today's government stupidity, on the one hand, but they really do also bring us huge economies of scale on the other. I see them as helping our check books, at the same time they're a positive threat to our liberties.

Yet nearly all libertarians I've talked to, disagree with me. They think mega corps are just fine, nothing to see here.

Mike Rulle writes:

J-K's prescriptions are the economic equivalent of Obama's health care fix. They seek comprehensive Government steering of free markets as the solution to an already overly and inconsistently regulated industry.

They are also biased to the view that the growth of financial transactions are pure rent seeking activities rather than, for example, an increase in liquidity.

How much of the financial crisis would have been avoided if AIG were required to post even nominal levels of initial and maintenance collateral for its CDS transactions? How much of the financial crisis would have been avoided if California, Florida, and Arizona did not have non-recourse (beyond the house itself) laws protecting borrowers? How much of the crisis would have been avoided if the Federal Government did not permit (require?) Fannie and Freddie to purchase sub-prime mortgages? What does "big" have to do with any of the above?

Why don't we start small--as we should in health car--before we start trying to remake systems from scratch.

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