Systemic Financial Crisis

Simon went on CNBC's The Call this morning to talk about the various forms of bank taxes that have been proposed since this December. Whether the idea was a windfall tax on bank bonuses around the new year, or the more recent $19-billion tax on large banks and hedge funds that was cut from the financial regulations bill, many Americans are convinced that bankers need to be made to pay. For Simon, the main question is whether these taxes can help us to create the dynamic economy we need in the 21st century.

Back in April, Simon asked an important question:

As the American government struggles with what to do with its new ownership stake in storied corporate brands like AIG, Chrysler, Citigroup and General Motors, one of the fundamental questions that must be asked now is, can these brands - after months of stories about their insolvency - be saved?

Simon wasn't so sure, and neither am I. But if I were an executive at one of these banks, I would be doing everything I could to repair my brand. One of the worst problems these banks have caused is the global impression that America caused an international financial meltdown, which has been, to say the least, bad for both these banks and America’s interests abroad.

So what can they do? Here at NDN, and in particular Sam duPont's Global Mobile blog, we have been covering the role of mobile technology in what the State Department is calling 21st Century Statecraft. One of the most exciting innovations in this space is mobile banking, which Sam has been discussing quite a bit, and I blogged about a year and a half ago. (Sam recently posted a video of Alec Ross, the Senior Advisor on Innovation to Secretary Clinton, discussing this.)  MBanking has the potential to revolutionize standards of living globally by connecting some of the world’s poorest economies to modern financial services without needing to create the physical infrastructure of a bank. 

So here’s my modest proposal to American bankers, a group of people who’ve been particularly good at innovating over the last two decades: Call up State, say you want to build - for free - a modern, mobile communication device based banking system for less developed nations and that you want to put your best people on it. 

Imagine if every time a sizeable percentage of the world’s population did a financial transaction, they knew it was because of the American government and the American financial sector. There’s plenty of profit motive in it for banks, as the additional customers alone would be a boon. Not only would this be great for America’s standing in the world and help these banks repair their image, it would have that nice added benefit of dramatically improving people’s lives.

Last week, I wrote about a David Brooks column that argued that the next great debate in American society is going to be about the best way to promote innovation in the economy. Indeed, innovation has been the lifeblood of the American economy, and it's heartening to see that much of the national conversation has turned to promoting innovation. But not all innovation is beneficial to society. Indeed, one of the sectors that has seen a great deal of innovation recently, some of which created sub-optimal results, was the financial sector. Calvin Trillin, writing in the New York Times, explains, in a sentence, why:

The financial system nearly collapsed…because smart guys had started working on Wall Street.

What Trillin goes onto explain is that smart people, instead of going into for example physics, started going into finance and started innovating. A lot - and much more than their less talented predecessors. (James Kwak at the Baseline Scenario says that this actually is probably true.) But, as Simon Johnson and Kwak have explained, much of the recent innovation in the financial sector hasn't necessarily been beneficial to anyone other than those doing the innovating. They differentiate between innovation that has made things better for consumers – the ATM for example – and innovation that involves easier access to credit, which isn't always as good:

In short, financial innovations whose sole function is to increase access to credit do not in and of themselves make the world a better place. They can help by providing the credit that people need to make the world a better place, but they can also make it possible for people to do irrational and economically destructive things. So when people say that innovation is the source of all progress, that may be true – but not all types of innovation are equal.

In the most recent Democracy Journal, which features a whole series of articles on innovation (incuding one by Johnson and Kwak), NDN's Dr. Rob Shapiro criticizes a proposal promoting the idea of utility capitalism, essentially government regulated monopolies or cartels. Michael Lind, the proponent of utility capitalism, argues that this framework would encourage innovation, which Shapiro debunks by explaining how, according to Nobel Laureate Kenneth Arrow, innovation really works:

Large, incumbent firms try to enhance the efficiency and reduce the costs of what they already do well. Younger firms have to establish a new place in the market, and since their size precludes competing on price, they have to compete in some area of quality, which often means innovation. [Cartels and monopolies, which preserve the incumbent status of large firms, therefore do not lend themselves toward innovation.]

Most of us can agree that for America to maintain its economic standing, our edge in innovation and the modern idea-based economy is crucial. Unfortunately, maintaining an edge in something so inherently dynamic as generating the ideas that create new and powerful companies, products, and services is difficult, and our ability to innovate is certainly not unlimited. 

Most would agree that it was a mistake in recent years to focus so much innovation on the financial sector as opposed to science, medicine, and making people's lives better, and Trillin's point paired with Shapiro's are crucial: America needs to create the incentives that move talented people into socially useful professions (like center-left Washington think-tanking) and create the economic incentives to produce socially useful innovation.

It was an auspicious week for the touchy issues surrounding executive pay.  One after another, President Obama’s pay czar, Kenneth Feinberg, announced new restrictions for AIG executives; Goldman Sachs was reported to be putting aside $23 billion this year’s bonus pool, the largest anywhere, ever; and Elinor Ostrom from Indiana University shared the Nobel Prize in economics for her breakthrough work on how large companies organize themselves, often in ways that encourage executives to put their own financial interests before those of the shareholders.   

Starting with Goldman, it’s obvious that a sheaf of annual bonuses each equal to 10 or 20 times what an average American earns in his or her entire lifetime, coming from a firm which recently received huge, direct and indirect taxpayer-funded assistance, is certain to spark outrage.   That reaction isn’t misplaced, and there’s a sensible response to it based on the core tenets of capitalism which we will get to shortly.   There are other serious matters at stake here, too.   In particular, how does a financial services firm like Goldman Sachs earn such huge profits in difficult times?  And since the operations of Goldman and a few others like it matter so much to the economy – which is why they got their federal assistance – how do the arrangements which produce such huge bonuses affect those operations and thereby the rest of us?   The answers suggest that even as Goldman’s top executives and traders put away enough for a royal retirement, their decisions could lay the foundation for future financial turmoil that would leave the rest of us a lot poorer.  

We didn’t need this latest and most conspicuous instance of greed at Goldman to know that the compensation provided to the uppermost echelons of American business is out of control.  Since 1990, the pay of American CEOs has jumped from 90 times the average workers’ pay to 250 times – compared to 15 to 30 times for British, French and Japanese CEOs.   Nobel Laureate Ostrom’s work helps us understand why:  CEOs name their own top executives and strongly influence who ends up on their boards of directors – and consequently on the committees that set the terms for all of their compensation.  How much they decide to pay themselves, therefore, is essentially limited by the intersection of their own avarice and any vestigial sense of shame they might have.   And the shame is pretty easy to dispose of, since the terms of their compensation are rarely disclosed publically.

There’s a fascinating account of some of these pay packages in a current New Yorker article chronicling the efforts of Nell Minow and Robert A.G. Monks to reassert shareholder rights over these modern robber barons. Almost everywhere, most of the pay comes in stock or stock options, so they’re only liable for the 15 percent capital gains tax.  (The Goldman executives who will claim stock bonuses worth tens of millions of dollars this year will report taxable “salaries” of less than $300,000.)  And if the stock price falls under these executives’ leadership, their options contracts are often revised at a lower strike price.   These packages may also include huge “retirement” bonuses for CEOs that leave voluntarily – like the one federal contractor Halliburton gave Dick Cheney when he left to run for Vice President – and even “retention bonuses” for executives who end up in prison.  Then there are the extravagant perks.  It took public divorce proceedings against GE’s Jack Welch for shareholders to find out that on top of the many hundreds of millions of dollars Welch received in stock and salary, his friendly board had also awarded him lifetime use of the company’s 737 and helicopters; lifetime floor seats for the Knicks and lifetime box seats for the Red Sox, Yankees and the Metropolitan Opera; exclusive lifetime use of a sprawling Manhattan apartment, including fresh flowers, dry cleaning service and even the tips for the doorman; and a catalog of lifetime golf and country club memberships.   His and most other executive contracts also now include “gross-ups,” which means that the shareholders pick up federal and state taxes owed on the executives’ various perks. 

These are all examples of what economists call the “agent-principal problem,” in which the interests of agents – they’re the executives – diverge from those of the principals, who here are the owners or shareholders.  It’s pretty simple: They enrich themselves at the expense of the shareholders who they ostensibly work for – and those shareholders now include a majority of all Americans.  The simple democratic answer to all this, derived directly from the essence of capitalism, is to empower the owners by requiring that boards disclose all aspects of the compensation package of senior personnel and subject the terms of those compensation packages to mandatory shareholder votes, every year.  

Last week, I proposed this step on a CNBC business show.   The other guest predictably squawked about government control – and then the moderators also tried to dismiss the idea as “impossible.”  Come again?  Shareholders vote every year on lots of measures – check out your proxy statements.   And the mere threat that shareholders might publicly reject a CEO‘s payday should moderate the greed of at least some compensation committees.   The House passed a weak version of this proposal recently – annual, “advisory” shareholder votes on compensation.  The Senate should strengthen it with stricter disclosure requirements and an annual vote that actually decides the matter. Why, precisely, shouldn’t a company’s owners determine what their executives are paid?  And does anyone think that Goldman’s shareholders, including strapped pension plans and charitable institutions, are eager to see $23 billion in potential dividends go to the firm’s top tiers?

This particular agent-principal problem also affects the rest of us, since the stock and stock options that make up most of these compensation packages are often tied to the short-term gains associated with an executive or trader’s work, without regard to the transactions’ long-term returns.  So, hundreds of traders and executives at Goldman and other places on Wall Street have closed transactions and other deals that booked large paper profits this year – and will take home huge bonuses tied to them – but bear no consequences if those deals go sour next year or the year after and cost the shareholders billions.   These arrangements directly encourage them to take on enormous long-term risks for their firms and owners, in pursuit of the short-term paper gains that generate their own bonuses.   Since risk and return are closely related, these arrangements help explain how Goldman earned enough this year to dole out that projected $23 billion in bonuses.   And by creating such strong incentives for risky investments on a large-scale, these same arrangements were a core element of the meltdown that nearly pushed the U.S. and global economies into a genuine Depression, and cost shareholders and taxpayers trillions of dollars.    

To prevent a recurrence that could ruin almost everyone, these arrangements have to end.  J.P. Morgan Chase has said it will include new “claw-back” provisions that would reclaim part of the bonuses when a deal’s long-term returns are less than expected.   It’s a nice gesture, but it’s hardly enough.  We need laws and regulations that directly limit the risk levels of the portfolios of institutions deemed “too large to fail,” and specific, claw-back guidelines from the SEC that all public companies will have to follow.  The outstanding question is whether Congress has the cajones to force the country’s richest people and institutions to change the ways that made them so wealthy in the first place.

NDN has long pointed out that median household income dropped by roughly a thousand dollars during the Bush era, creating a middle class that was weakened even prior to the great recession. Now, Census Bureau data tells us that household income has again dropped, meaning that everyday Americans have taken a loss over the last decade. From the New York Times:

In another sign of both the recession and the long-term stagnation of middle-class wages, median family incomes in 2008 fell to $50,300, compared with $52,200 the year before. This wiped out the income gains of the previous three years, the report said.

Adjusted for inflation, in fact, median family incomes were lower in 2008 than a decade earlier.

"This is the largest decline in the first year of a recession we've seen since the Census Bureau started collecting data after World War II," said Lawrence Katz, an economist at Harvard University, referring to household incomes. "We've seen a lost decade for the typical American family."

Coupled with rising costs, specifically in health care (I'm sure you've heard about this recently), energy, and pensions, dropping incomes mean that the economic wellbeing of everyday Americans is significantly worse than a decade ago. Add in all the wealth destroyed by the systemic financial meltdown and the collapse of the housing market, and we're talking about an economically crippled American middle class.

Below, please find my comments today on the reappointment of Federal Reserve Chairman Ben Bernanke and the new OMB report estimating that the deficit will reach $9 trillion over the next decade.

On the new OMB estimates:

The new numbers today from the Office of Management and Budget remind us that short term and long term deficit projections are very uncertain. What is equally certain is that the economy needs stimulus today, whatever the short term cost to the deficit, as well as sharp reductions in long term deficits. Those long-term reductions have to form the basis for the other reforms in health care, energy, education and training which our economy and nation need. Addressing both of these tasks remains the administration’s most important domestic challenge.

On Chairman Bernanke's reappointment:

Chairman Bernanke did not see this crisis coming, but he steered the economy well once it arrived. The country still needs his wisdom, because this crisis is not over. Our large financial institutions remain fragile, as they continue to hold most of the toxic assets which brought down other financial giants. The economy remains vulnerable to additional shocks from the financial system, including the deteriorating commercial real estate markets. Foreclosures continue to rise, which in turn drain more of the value of the mortgage-backed securities still held by financial institutions. The only reason we haven’t seen greater effects is that we suspended their mark to market accounting. But underneath the bookkeeping, these problems remain serious. All of this portends a very challenging economic environment and the prospect of a difficult recovery. The President was right to opt for continuity in the face of this large and critical agenda, which we hope Chairman Bernanke will help resolve.

There are few better ways to sink one's hopes about the future than to read pessimistic economists. In that spirit, Nouriel Roubini in the Financial Times and Paul Krugman in his New York Times blog write yesterday and today, respectively, about the likelihood that the Great Recession is U shaped or even (in Roubini's case) W shaped. Both see a U shaped recession as probable, and Krugman shows, with this chart, what a U shaped recession looks like and why that means a jobless recovery - aka "purgatory" -

Furthermore, Roubini sees a very real possibility of this recession being W-shaped, which would be very bad news indeed:

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation).

But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation.

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

In summary, the recovery is likely to be anaemic and below trend in advanced economies and there is a big risk of a double-dip recession.

In an article leading with Larry Summers' call on banks to increase lending, President Obama's National Economics Advisor gives Bloomberg reporters an update on the status of the economy:

Summers said the U.S. economy is "no longer in freefall," and poised for recovery starting this year. The former Treasury secretary and Harvard University president cited recent increases in exports, and said fiscal-stimulus and foreclosure- relief programs will create a "gathering force" in the coming months.

Even so, income growth may not "resume in the near term," he told Bloomberg editors and reporters.

"The pace of growth next year, I think, is very much in doubt and difficult to predict," Summers said. That "will depend crucially on our effectiveness in implementing the programs that have been legislated" and what Congress may do on health care, financial regulation and energy, he said.

Today in the Washington Post, Treasury Secretary Tim Geithner and Director of the National Economic Council Larry Summers outline the administration's plans to regulate the financial system. While these reforms will not get the same attention as the other major initiatives President Obama is trying to pass this year, they are incredibly important to our continued prosperity, and the post crisis shape of the financial system is a fascinating story to follow. One also notices that the "New Foundation" theme is repeated for the op-ed. Here's what the President's top economic advisers had to say:

Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.

We have taken extraordinary measures to help put America on a path to recovery. But it is not enough to simply repair the damage. The economic pain felt by ordinary Americans is a daily reminder that, even as we labor toward recovery, we must begin today to build the foundation for a stronger and safer system.

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.

Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week -- at the president's direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts -- the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.

Read the whole piece here.

Stockholm -- The best way to clear your head of the political chatter that passes for policy debate in Washington is to get out of town. I’m writing today from Stockholm, a grand old city on a picturesque harbor and archipelago, where it’s harder to care much about Larry Summers’ squabbles with White House colleagues, the cynical fulminations from Newt Gingrich or Rush Limbaugh, or even the heated discussions inside Obamaland over its legislative strategy for health care reform. With a little distance, it’s easier to focus on developments which may actually matter for the rest of us, such as the prospects of Iran electing a democratic reformer as president this week or how the unfolding, deep slump in global trade may imperil economic recovery by China, Japan and Germany.

 It’s also easier to concentrate on our own economic conundrums. Let’s start with the crying need for new financial regulation that can prevent a system whose dysfunctions have just wiped out 20 percent of America’s wealth from doing it all over again sometime soon. The current TARP program, now officially a tangled mess, isn’t much of a model. This week the Treasury announced that 10 large institutions will be permitted to repay their TARP loans, including Goldman Sachs and Morgan, while nine others, including Wells Fargo, Bank of America and Citicorp, have to stay in the system. It sounds reasonable, since the lucky 10 can afford to repay while most of the rest cannot. But the TARP system ties regulation to outstanding loans, so now we’re left with a two-caste financial market where the weaker ones operate at a market disadvantage and others who used the taxpayers to fund their comebacks are no longer constrained to operate in the interests of a public which rescued them less than nine months ago.

We also learned this week that the Treasury’s clever plan to use taxpayer guarantees to create a private market for the toxic assets of all these institutions is a flop: Even with all that largesse, nobody wants to buy much of the toxic paper. So if the economy dips again, the 10 institutions now exiting the TARP regulations will be back for more, and there won’t be enough money in the Treasury or the Fed to save Citicorp and Bank of America again.

Then there’s the matter of how to regulate the derivatives that knocked the pins out from under the vaunted U.S. financial markets last year. The Administration’s current economic mandarins, along with the most elevated mandarin of all, Alan Greenspan, all have confessed publicly to their errors in dismissing the need for such regulation in the late-1990s. With the catastrophic collapse of the multi-trillion dollar markets for mortgage-backed securities and their credit default swap derivatives, strict regulation of these transactions to protect the rest of us -- which basically means transparency and reasonable limits on the leverage used to create or buy these instruments -- should be a no-brainer.

So what’s the logic behind the Administration's decision to keep trading in large, “private” deals in derivatives outside regulated markets? Those are precisely the deals that pose a danger for the rest of us, since they’re the large ones and inevitably the deals carried out by the institutions now acknowledged to be too large to fail. That’s Washington-speak for companies important enough to demand help from the taxpayers whenever they need it. The justification is the same as in the 1990s -- it will reduce their profits. That’s correct, in order to protect the rest of us from the now well-known consequences of a mindless drive for higher and higher profits regardless of the risks.

The next time you feel yourself drawn to the insider accounts of the greasy pole inside the White House or the breakup of the Republican coalition, take a deep breath and remind yourself that these are the players actually responsible for serious matters that ultimately may determine whether you ever have the income and assets required to send your kids to college or retire before you’re 80 years old.