Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz professor of entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
The global financial crisis that broke out following the collapse of Lehman Brothers in September 2008 was a big shock. This is literally true in terms of the impact on investors and market prices; a wide range of financial variables moved rapidly in unexpected and worrying directions. But what happened was also a shock to the realm of ideas about finance.
TODAY’S ECONOMIST
Perspectives from expert contributors.
Before September 2008 — or at least before 2007, when some of the underlying problems first became more clearly manifest — the prevailing consensus among officials and specialists was that financial innovation was a good thing. In isolated instances, a particular new product might not work out as planned, as happens, for example, with medical innovation. But over all, the consensus went, financial innovation led by the private sector was making the system safer and more efficient.
This view was wrong.
In its day, this line of thinking justified the legal and regulatory changes that allowed some banks to become very large and to build up a much more complex range of activities in the 1990s and early 2000s, including through various kinds of opaque derivatives transactions.
In retrospect, much of the financial innovation in the previous decades built up risk for the financial system in ways that were not properly understood by regulators or, arguably, by management at some of the largest banks.
Of course, some bankers knew exactly what they were doing as their companies increased their debt relative to their equity. On average, large complex global banks had about 2 percent equity and 98 percent debt on the liability side of the balance sheet before the crisis, meaning they were leveraged 50:1 (the ratio of total assets to equity).
The good news is that the official consensus was shattered in 2008, and is not coming back. Systemic risk slapped everyone in the face with an undeniable wake-up call.
However, the process of reforming the financial system is still at an early stage. The Dodd-Frank financial reforms of 2010 represent a useful start — including the Volcker Rule‘s restrictions on excessive risk-taking — and the recently adopted Basel III framework for capital regulation nudges equity requirements higher.
But the world’s largest banks will, by one informed estimate, end up — as things currently stand — with about 3 percent equity and 97 percent debt as the average structure of their balance sheet liabilities. In the United States, if the latest leverage rule is implemented and enforced properly, this will become 5 percent equity and 95 percent debt for the biggest eight banks by 2018. While 20:1 is better than 50:1, this is still not enough equity to assure a reasonable degree of financial stability in the foreseeable future.
The argument about finance has now shifted and is much more about whether capital requirements for the largest banks should be increased further. Those opposed to such a move offer three reasons why big banks should not be required to fund themselves with much more equity.
First, some people contend that the crisis of 2008 was a rare accident and Dodd-Frank fixed whatever problems existed. This is completely unconvincing — particularly because many of the same people have spent much of the last four years opposing and delaying financial reform.
Most importantly, it ignores the ways in which incentives and rules have changed since the 1980s. As James Kwak and I asserted in “13 Bankers,” the structure of the financial system is quite different now from what it was in 1980. In particular, the largest banks have become much bigger and more able to take on (and mismanage) much more risk.
The second argument is that the costs of the crisis were not huge, so there is no reason to fear a repeat. This is the view sometimes associated with former Treasury Secretary Timothy Geithner. (Mr. Geithner has a book coming out soon, and it will be interesting to see his current position on this point).
But the impact of any financial crisis is not measured primarily in terms of whether the Treasury made or lost money on specific investments. The criteria instead should be what happened to output and jobs, as well as what the impact was on the country’s fiscal accounts. How much more public debt do we have now relative to what we had before — and what kind of lasting negative effects will that have?
Mr. Kwak and I took this on in “White House Burning,” putting the recent surge in public debt in the longer-run context of American fiscal policy. No matter how you look at it, the financial crisis was a complete disaster for the real economy and, given the way fiscal politics work in the modern United States, for the budget and for investments in any kind of physical infrastructure and education.
The third counterargument is that large complex financial institutions are needed because they provide some sort of magic for the broader economy. This still seems to be the view of some people at the Federal Reserve Bank of New York, which recently published a set of research papers on the topic.
But the benefits they find are small relative to the potential costs. Anat Admati and Martin Hellwig’s “The Bankers’ New Clothes” makes the vulnerability of modern banking abundantly clear.
A recent report from the International Monetary Fund finds that the United States and other governments are providing large implicit subsidies to these big banks: The prospect of potential government support lowers their funding costs by about 100 basis points (one percentage point).
Many people are involved in the official sector’s rethinking of finance. This is the lasting contribution from books such as Sheila Bair’s “Bull by the Horns,” Neil Barofsky’s “Bailout” and Jeff Connaughton’s “The Payoff.” In government circles, key decision makers were swayed by officials including Thomas Hoenig and Jeremiah Norton (both of the Federal Deposit Insurance Corporation) and Sarah Bloom Raskin (then on the Board of Governors of the Federal Reserve System; now at the Treasury Department). As chairman of the Commodity Futures Trading Commission, Gary Gensler had an immensely positive impact, both directly on the regulation of derivatives and also more broadly.
The Democratic senators Sherrod Brown of Ohio, Jeff Merkley of Oregon and Carl Levin of Michigan and Ted Kaufman of Delaware (who has since left the Senate), along with David Vitter, Republican of Louisiana, played key roles in shifting opinion. Elizabeth Warren’s work, both before and after her election to the Senate from Massachusetts, has also had great influence.
Of all the civil society organizations seeking to promote financial stability, Dennis Kelleher’s Better Markets stands out for its major impact through a relentless surge of arguments, comment letters and research. Its report on the cost of the crisis made clear beyond any reasonable doubt that the crisis had profound negative consequences for millions of people.
Many other officials have also shifted their views in important ways. We are not going back to the old ways of thinking about finance, and allowing for changes in these theories is an essential part of any modern economy. Finance needs to be regulated effectively, and large banks should fund themselves with much more equity than is currently the case.