Paul Krugman and Simon Johnson are two of my favorite economic commentators, consistently providing clear analysis of the causes of the Great Recession and proposing solutions to revive the economy and to prevent future meltdowns.
But when it comes to one of the central issues of our times--whether or not to break up the biggest banks which now control assets totaling more than 60% of GDP--Johnson and Krugman take dramatically opposing positions. Johnson says that shrinking Too Big To Fail ("TBTF") banks is essential to our economic and political future. Krugman says it wouldn't solve our problems.
In his Huffington Post Book of the Month 13 Bankers (co-written with James Kwak) and in his blogs on Baseline Scenario and Huffpo, Johnson (former Chief Economist for the International Monetary Fund and an MIT Professor) makes the case, in clear and compelling terms, why, in addition to regulatory reform, breaking up the biggest banks is vital to preventing the next round of economic boom and bust and the next round of multi-trillion dollar taxpayer funded bailouts.
In contrast, Krugman's recent New York Times columns and blogs argue that the size of the largest financial institutions is largely irrelevant and the solution lies in new regulations alone.
Krugman seems to think tighter financial regulation and breaking up TBTF banks is an "either/or" proposition. Why? Johnson's "both/and" approach makes much more sense.
Krugman may have the "pragmatic" short-term politics sized up correctly--President Obama and his Wall Street-friendly team of Summers/Geithner/Emanuel and crowd want to tinker with regulation on the margins while leaving the fundamental pre-meltdown structure of the financial system intact, so they oppose measures to shrink the TBTF banks and tend to marginalize people who advocate it. Krugman's tact seems to be to not alienate the administration and to suggest ways to improve their regulatory tinkering.
But Johnson has the long-term politics right--unless we break up the 6-8 largest banks which dominate the financial system, we will both be strengthening a self-perpetuating oligarchy which dominates the political system to protect its own wealth and power to the detriment of the national interest and democratic governance, and which uses it's government guaranteed "too big to fail status" to take excessive risk which will lead to the next bubble, the next meltdown, and the next Hobson's choice by an even more debt-ridden government between bailing them out again with trillions in taxpayer dollars or allowing them to fail and sinking the economy into depression.
Why does Johnson (along with other leading economists like Joe Stiglitz, Nouriel Roubini and Dean Baker, and even old-school bankers and regulators like Paul Volker, Kansas City and Dallas Fed Presidents Thomas Hoening and Richard Fisher, Bank of England head Mervyn King, and even Alan Greenspan) agree--contrary to Krugman and most of the Obama administration--that Too Big To Fail is Too Big To Exist?
There are two sets of arguments, the first economic and the second political.
First the economic argument: TBTF is antithetical to "free markets". TBTF financial institutions have a built-in, government-guaranteed, competitive advantage over smaller banks. Capital markets realize that no matter how risky the bets taken by TBTF banks are, no matter how likely TBTF banks are to eventually lose many of those bets and teeter on the brink of financial collapse, the federal government and the Federal Reserve can be counted to bail out TBTF banks with hundreds of billions or even trillions of dollars of taxpayer money. This implicit government guarantee makes it easier for them to raise capital and at a lower cost than smaller community banks, and such competitive advantage allows them to grow ever bigger and continue to pay-out ever larger bonuses to their top executives and traders and ever bigger contributions to their political friends, at least until the next inevitable meltdown and the next inevitable bailout. What's worse, it encourages them to make bigger and bigger bets on bigger and bigger risks, knowing that if they win, they pocket the outsized profits and if they lose the taxpayers will again bail them out. Thus the next financial bubble, the next financial meltdown, and the next taxpayer-funded bailout accompanied by the next Great Recession (or depression) are already baked into Too Big To Fail. Except next time, unemployment is likely to be higher at the start of the crises, and the federal deficit several trillion dollars larger, making the impact on the real economy even greater, and making it even more likely that the next financial meltdown and bailout could result not just in a Great Recession but another Great Depression.
Second, the political argument: TBTF is antithetical to democracy. Because of their TBTF competitive economic advantage, the largest banks have become even larger since the beginning of the Great Recession in fall 2008 and the 6 largest banks now control assets totaling over 60% of the country's Gross Domestic Product. With this outsized control of the economy comes outsized control of the government. A bank with assets exceeding 2 trillion dollars can spend whatever it takes to influence elections and convince Congress to pass legislation that favors its interests rather than those of the vast majority of middle class voters, especially after the Supreme Court's pernicious decision in the Citizens United case allowing unlimited election contributions by corporations. "Oligarchy" is a term Americans used to apply to countries like Russia and smaller third world countries, not to ourselves. But with TBTF, as Johnson and Kwak explain,
"The Wall Street banks are the new American oligarchy-- a group that gains political power because of its economic power, and then uses that political power for its own benefit. Runaway profits and bonuses in the financial sector were transmuted into political power through campaign contributions and the attraction of the revolving door. But those profits and bonuses also bolstered the credibility and influence of Wall Street; in an era of free market capitalism triumphant, an industry that was making so much money had to be good, and people who were making so much money had to know what they were talking about. Money and ideology were mutually reinforcing.
This is not the first time that a powerful economic elite has risen to political prominence. In the late nineteenth century, the giant industrial trusts -- many of them financed by banker and industrialist J. P. Morgan -- dominated the U.S. economy with the support of their allies in Washington, until President Theodore Roosevelt first used the antitrust laws to break them up."
So, argues Johnson, to preserve democracy, and to prevent the next bubble, meltdown and bailout,
"Make our largest banks small enough to fail. There is simply no other way to really end the problem of 'too big to fail.'"
Fighting to break up TBTF banks would also be good politics for Democrats, particularly if it's opposed by Republican. There's anger in the land about the banks receiving hundreds of billions in taxpayer bailouts, giving nothing in return, and paying out hundreds of millions in bonuses, while millions of Americans lose their jobs and their homes. Obama and the Democrats are increasingly seen by voters as too cozy with Wall Street while Republicans are getting a free ride. Voters don't necessarily understand the regulatory intricacies of capital ratios and the like. But they'd damn well understand and cheer if the Democrats demand that Goldman Sachs and Citicorp be cut down to size and the Republicans defend the big banks. Obama shouldn't be promising, as Johnson quotes him as telling the CEO's of the 13 largest bank, that his administration will stand between them and the pitchforks. He should be helping to channel the anger of the people with pitchforks into breaking up TBTF banks and regulating the smaller financial institutions that remain. Otherwise, he's encouraging the rise of the Tea Parties and the resurgence of the Republican Party that will then thwart even his modest reform agenda.
Paul Krugman -- who less than a year ago was calling for a temporary government takeover of failing TBTF banks -- a bit surprisingly disagrees with people like Simon Johnson and Paul Volker that the government should break up the TBTF banks. In a recent New York Times column he writes:
"Here's how I see it. Breaking up big banks wouldn't really solve our problems, because it's perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that's precisely what happened in the 1930s, when most of the banks that collapsed were relatively small -- small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.
The same would be true today. Breaking up big financial institutions wouldn't prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn't be concentrated on a few big companies -- but it would be a bailout all the same. I don't have any love for financial giants, but I just don't believe that breaking them up solves the key problem.
So what's the alternative to breaking up big financial institutions? The answer, I'd argue, is to update and extend old-fashioned bank regulation. "
Here' why I think Krugman is wrong and Johnson and Volker, et al, are right. First, it may be true that shrinking the size of the TBTF does not provide an iron-clad guarantee against future financial crises and bailouts. But it makes them less likely. It may be that the bank run that helped trigger the Great Depression occurred with respect to hundreds or thousands of smaller banks. But Federal Deposit Insurance has largely corrected the threat of retail consumers panicking and causing a run on smaller banks and indeed, in the nearly 80 years since then, there's been no similar panic. During the S & L crisis of the 1980's, the FDIC took over and reorganized over 700 smaller banks without causing a major recession. In a subsequent column entitled "Georgia on My Mind", Krugman points out that due to lack of regulation, small banks in Georgia recently have failed at a greater rate than those in other states. But that only proves the point he's trying to refute -- their failure did not lead to a systematic threat to the financial system. By all means, regulate them with a Consumer Protection Agency and other measures, but that's not an argument against breaking up TBTF banks that pose a higher systematic risk. In addition , even if there's still some systemic danger of a crisis originating in smaller banks, that's no reason not to take steps to prevent the much more likely danger of a crisis originating in TBTF mega-banks. That's like saying, "Protecting my house from fire wouldn't really solve my problem, because it's perfectly possible that my house could be destroyed by a flood."
Moreover, Krugman seems to make imposing stronger regulations on the financial system or breaking up the TBTF banks an either/or proposition. But it's not. We can do both/and. As Johnson argues,
"Making our largest banks smaller is not sufficient to ensure financial stability. There are many other complementary measures that make sense -- including higher capital requirements, more transparency for derivatives and generally more effective regulation. But reducing the size of our largest banks is absolutely necessary if we are to reduce the odds of another major financial catastrophe."
Finally, Krugman seems to put too great a faith in regulation, ignoring the problem of regulatory capture. For those not familiar with it, "regulatory capture" is the idea that there's a tendency for regulators to be captured by the very institutions that they're supposed to be regulating. New regulatory legislation tends to start out with a big bang. But the details of regulation are complex and boring and within a few years, the public stops paying attention and the only ones paying attention are the civil servants paid to implement the regulations and the institutions being regulated. Pressure for strong regulation diminishes. The regulators increasingly come to identify with, or be intimidated by, the regulated institutions, particularly when the regulators are earning government salaries and the regulated institutions employ Ivy League-educated executives and lawyers making hundreds of thousands or millions of dollars a year. Experienced regulators often leave the government and go to work for more money working for the institutions that they formerly regulated, and don't want to alienate their potential future employers. And if a regulator does get too aggressive, a top executive of a TBTF institution like Jamie Dimon of JP Morgan Chase or Lloyd Blankfein of Goldman Sachs can always pick up the phone to a favorite Senator or Treasury Department official who will in turn call the regulator's boss and tell them to back off.
Even after the deregulation of the '90s, regulators like the Securities and Exchange Commission and the Federal Reserve still had plenty of power in the first decade of the 21st century to reign in the excesses of the biggest banks that led to the great meltdown of 2008. The problem is that they came to see things the same way as the heads of the big banks and did next to nothing until Lehman Brothers went under, Tim Geithner and Hank Paulson bailed out AIG, and Paulson came begging to Congress for $700 billion in TARP funds for the banks to prevent financial disaster.
It's not that Krugman's wrong that stronger financial regulation is necessary. It's that it's not sufficient. As Simon Johnson argues, unless TBTF banks are cut down to size, they will use their implicit government guarantee to grow even larger, take even bigger risks, and make the next meltdown and next bailout inevitable.
"If the basic conditions of the financial system are the same, then the outcome will be the same, even if the details differ. The conditions that created the financial crisis and global recession of 2007-2009 will bring about another crisis, sooner or later. Like the last crisis, the next one will cause millions of people to lose their jobs, houses, or educational opportunities; it will require a large transfer of wealth from taxpayers to the financial sector; and it will increase government debt, requiring higher taxes in the future."
Krugman may be taking the more pragmatic political path than Johnson, preserving his access to the White House by refusing to challenge their failure to support the breakup of the TBTF banks, in the hopes of influencing them to strengthen regulation. But in the long run, the results are likely to be disastrous. It may take time -- more than just a year -- to win the battle to break up TBTF banks, particularly with the Obama administration standing with the banks in opposition. It will probably take a mass movement. But such a movement also needs to win the battle of ideas. Johnson is helping to win that battle. Unfortunately, by siding with the White House, Krugman is lending his influence to help undermine it.