John R. Talbott is a former investment banker with Goldman Sachs and the author of "The 86 Biggest Lies on Wall Street," "Contagion," "Obamanomics," and "The Coming Crash in the Housing Market."
Simon Johnson, the former chief economist of the International Monetary Fund (IMF), is the co-founder of the Baseline Scenario, a Web site tracking the ongoing financial crisis. He is one of the most visible public commentators on the ongoing financial crisis and its causes.
From June to July of 2009, Talbott and Johnson held an e-mail conversation on the following topic:
"The economic crisis: Who caused it? Was it preventable? Was criminal activity involved in bringing it about? And is it over?"
The exchange below is the second of three sets of e-mails. The first pair was published Wednesday, and the final pair will appear Friday.
From: John Talbott
To: Simon Johnson
Subject: Complexity With No Purpose
Simon,
You make some very good points [in your first e-mail]. Let me try to address some of them, and in so doing extend this e-mail exchange into a conversation about the real reforms needed.
Don't worry, this isn't over yet. We haven't missed our chance to enact real reform. There isn't going to be any big recovery until we address these fundamental issues. Given the debt overhang, the banks' general unwillingness to lend, the lack of transparency and trust in the markets, the possible change in people's desire for increased status-seeking through crazy borrowing and crazy consumption, a substantial decline in immigration and population growth, and the fast approaching retirement of the baby boomers, I don't see the American economy growing in real terms for years, if not decades, into the future. The real risk is that the economy will continue to suffer, unemployment will increase, and discontent will grow to the point that the Republicans stage a comeback. It may sound far-fetched now, but I can tell you: There is enormous anger out there about government spending, the increased debt, the bailouts and the fact that Washington is still taking orders from special interests. This is not the change people signed on for.
You are right -- this is much bigger than Bernie Madoff and his friends stealing billions from investors. Because the banks lobbied to change the law before they acted, their actions are technically legal. But paying elected representatives money to change laws so that you can violate them seems to me to be at the heart of what criminal activity is all about. But you are right, because the laws were changed, criminal prosecutors in the states are not going to be very effective in bringing effective prosecutions, especially given that federal enforcement agencies like the FBI and the SEC [Securities and Exchange Commission] are collecting so little useful evidence and pursuing so few leads.
It is a real question how a country can stop corruption once corruption reaches its legislature, since the legislature is the place where we would expect reform legislation to be enacted. I believe this is one of the reasons why the poorest countries of the world have remained poor for centuries. As we have seen here in the U.S., once you lose control of your legislature, accomplishing real reform is a much bigger problem. Prosecuting attorneys are not going to be much help, judges and the court system have their hands tied by corrupt legislation, and well-meaning presidents face ostracism inside the Beltway if they openly oppose Congress, lobbyists and corporate special interests.
I believe pressure for reform has to come directly from the people. And I believe that Washington is so corrupt that attempts to bring reform through the vote will be ineffectual. The two parties have too much of a lock on power while incumbents have too much money (and they have gerrymandered their districts to the point that their losing is near impossible). Congress' approval rating of 14 percent and congressional incumbents' 98.4 percent success rate at re-election fully describes the problem of attempting reform through the vote.
That is why I am starting an effort to organize Americans who are angry with the power of corporate special interests to take back their country by putting pressure not on the corrupt Congress, but on the source of their funding: our biggest banks and corporations. Follow the money. [Anyone interested in further information can contact Talbott at johntalbs (at) hotmail (dot) com.] The task is getting Americans organized, because once organized we hold the ultimate trump card. It is we Americans who make these corporations what they are today by buying their products and services. Any threat to not buy the products of big government lobbyists would certainly get their attention. I honestly believe it is also in the interest of our biggest corporations to stop influencing our government, because until they do, so our country is not going to be seeing any real economic growth. Banksters, greedy healthcare companies, a weak education system, unnecessary wars and a bankrupt government trying to fund its retirees' costs are not conducive to economic growth, and the corporations should come to realize this. This is a classic collective-action problem where each corporation cheats and steals a little, but the overall effect is to strangle the economy and prevent a truly prosperous future.
Of course, the real reforms that need to be accomplished, once we get corporations out of Washington and politics, include limiting the leverage of banks and prohibiting them from risky activities -- principal trading for their own account, derivatives trading, and many other investment banking activities -- and assuring complete transparency of all of their positions. We also need to strengthen the board supervision of management by getting managers, including the CEO and his cronies, out of the boardroom and replacing them with real shareholder representatives. We don't need to limit compensation, but we need to make sure that it is structured so that toxic waste cannot be left behind by a poorly thought-out bonus system.
But there are bigger reforms that are also needed. We need to downsize all corporations, especially the banks. We need to make sure they are not too big to fail. This downsizing will not hurt investors, as they will get two new smaller company shares of equal worth for every big old company share they held.
We need to shut down the credit default swap (CDS) market, because extensive trading of default risk makes everyone too interconnected to fail. I know the CDS market was created to limit risk through hedging, but it has done just the opposite. It has made all firms so interconnected that one cannot fail without bringing them all down. This violates the first rule of capitalism -- that firms must be allowed to fail -- and therefore it needs to be stopped completely. The only analogy I can think of to demonstrate how crazy this market has become is to go back in history to the early days of risk sharing when well-capitalized institutions on shore offered insurance against the loss of a ship at sea. The CDS market, if it were operating back then, would have allowed ships at sea themselves to guarantee the fate of other ships at sea, with very small boats such as hedge funds somehow insuring the return of very large merchant ships. The whole mess would have become so interconnected that one ship's sinking would have bankrupted everybody.
People today seem to think that just because two people want to trade something, it must be good. Because the CDS market is big, it must be useful, goes the argument. It gets at the belief system that you suggested people have adopted: that markets are inherently good. Maybe always efficient, but not always good. There are some things like company default risk that shouldn't be traded. In the past people wanted to buy and sell slaves, child pornography, women's bodies, or weapons of mass destruction, or to offer payments to elected government representatives and bribes to international governments and competitors. Just because a market can develop does not mean the functioning of that market is good for society. Markets cannot self-reflect. That is what humans do. Only we can decide if a particular market is doing more harm than good.
I would extend my reforms to include shutting down most derivatives trading. If used properly, it can be an effective hedging tool, but since its introduction it has made investment analysis moot, as no one actually knows what risks you are buying when you buy the stock of a company or bank actively engaged in derivatives. You may be bullish on gold prices, so you buy a gold mining stock -- only to find out that the company has in fact hedged its gold exposure so effectively through derivatives that it makes money only if gold prices decline, not increase.
Similarly, I would shut down the hedge fund industry. They are nothing more than enablers for these banks and companies like AIG to concoct schemes to avoid regulation or increase risk. Basic investment theory says you can't beat the markets, so I will bet that the hedge funds that are claiming to do so are doing it illegally through insider trading and market manipulation of individual stocks and asset prices. Don't take my word for it. Let's have the government tap the phones and check the e-mails of the hedge funds for a six-month period on a confidential basis and see what happens to their reported outsized profitability and trading brilliance.
John
From: Simon Johnson
To: John Talbott
Subject: Re: Complexity With No Purpose
John:
Thanks for your follow-up note.
I take your point that there should be a great deal of popular anger -- there is certainly plenty of reason for ordinary voters to be upset. But I'm not so sure this will be manifested anytime soon; for most people, what has happened is a bit abstract and rather too confusing.
On top of this, the big banks have done a great job of muddying the waters. Their message gets through to many: Everyone is to blame and no one is responsible for the crisis, so let's go back to some version of business as usual.
I actually agree there will be change, but I would suggest three other ways in which this will be manifested.
First, the financial sector has become so bloated that going back to any version of "business as usual" is inherently difficult. Even ardent supporters of the financial sector think that much of its supposed growth since the mid-1990s is likely to evaporate. And there is no one who thinks that finance can continue to expand its already high share of our national economy.
In our bubble/boom, we overbuilt, just like Japan overbuilt in the 1980s. Japan added excessive commercial real estate and too much manufacturing capacity; it took more than a decade to work off that overhang and the associated corporate debt. We overbuilt residential real estate to some degree, but mostly we overbuilt financial services. That overhang could disappear fast -- buildings decay over time, but financial services are just people sitting in front of computers. Turn off the perceived business model and there's nothing left -- except perhaps too much office space in former financial centers.
Of course, it is possible that this aggregate contraction will come in terms of exits by smaller players in the financial markets, rather than downsizing the biggest banks. This would be ironic and also dangerous -- the real problem we face is from the banks and other financial firms that are "too big to fail" because they are so large relative to the financial system. If the biggest banks end up increasing their political and economic market share, this would not be good.
In this context, my second potential mechanism will be important. As you suggest, much of what passes for "financial innovation" is actually various ways to rip off customers. The biggest, most "sophisticated" banks have become very good at getting people to overpay.
Resistance to this kind of overpayment is growing. The existing level of fees, implicit and explicit, for all kinds of financial services has moved from irksome to completely unacceptable. Disappointed customers and rising competitive pressures are forcing these fees down. All of finance will be affected, but the biggest hit should be on the banks that are more about "rent extraction" than actually intermediating money from savers to borrowers.
The big banks are definitely in this line of fire. You're going to see some aggressive new entrants, undermining all manner of previously effective cartels, at the same time as fewer transactions and lower fees.
Third, there is great frustration and mounting anger among other members of our business elite. What the big banks have gotten away with is absolutely not in the interest of "real economy" entrepreneurs and the venture capital that backs them financially. It's also not in the interest of small and medium-sized banks who find themselves under increasing pressure -- particularly as commercial real estate goes bad -- but who are small enough and politically unconnected enough to fail. And the executives who run large nonfinancial corporations are beginning to figure out how badly they got clobbered and by whom.
They are worried about the budget deficit, about the issue of money, and -- most of all -- about their future taxes. All of these worries are completely appropriate. And they understand very clearly who is responsible: the biggest of the big banks.
Why does this matter? These business elites wield great influence, partly behind the scenes. They are increasingly articulating to their contacts in the administration and on Capitol Hill that "too big to fail" is no longer acceptable.
I hear more and more, including from influential people in the financial sector, that there needs to be some sort of "tax" (speaking loosely) on size in finance. There is a growing consensus that if you are big enough to jeopardize the financial system and to require a future bailout, you should pay for that privilege.
The payment can be in terms of higher capital requirements or something else. There are many ways to make this work -- as Deng Xiaoping said, "It doesn't matter if the cat is black or white, as long as it catches mice." The cult of size within the financial sector is over.
Overall, I may be more optimistic than you about change for Big Finance being on the way. But I'm probably less positive about where this ends up more broadly for society. You have a long list of reforms throughout society, and while we can argue the details, I'm broadly sympathetic to many of your points.
These mechanisms for imposing change on Big Finance, however, would do little to move things forward on a broader front.
That needs a more comprehensive national leadership push. Personally, I have not given up on President Obama -- I think much of his strategic agenda makes sense and many of his tactics are sensible, but the banking crisis is still an Achilles' heel. If he can get past that, and put the big banks back in their (smaller) boxes, I'm optimistic that he will have the opportunity to push over time for more extensive reforms.
And if not him, who?
Thanks,
Simon
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