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|Some dangers in a quick US recovery|
|Saturday, 20 June 2009 06:50|
In the US, things are moving. All the signs suggest that the economy is stabilizing. Stock markets are recovering, interest rate spreads declining, and business and consumer confidence improving.
Growth will start soon. Growth will be weak, perhaps for a long time, because financial institutions have to unwind their bad loans (“de-leveraging”), and consumers have to rebuild their savings.
Some US banks have declared profits and have been raising finance. Ten banks have repaid US Federal Government assistance in part because they do not want to be bound by the conditionality like executive salary caps or requirements to write off bad loans – and also because they want to regain their credibility.
Treasury Secretary Tim Geithner has now brought forward his proposals for reforming the financial sector. They are measured, incremental and marginal, but not a bold overhaul. They try to strike a balance between all the various interest groups. In many ways, the US financial regulatory landscape seems too complicated to reform, a cumbersome system that has evolved piecemeal over 150 years. There are literally hundreds of different regulatory organizations, at both federal and state levels. This meant that financial institutions would often choose their regulator (regulatory arbitrage), while some regulators even competed for jurisdiction over institutions.
The main elements of Geithner’s proposals are as follows. First, he would establish a Financial Services Oversight Council to help identify emerging overall systemic risks, with members being the heads of all the major federal financial regulatory agencies. This function is necessary because in the US’s fragmented regulatory system no-one had an eye on the whole system, and systemic risks were hidden away in unsupervised places like AIG. This body would only be an advisor to the Fed which would take on the responsibility for supervising the largest, most complex and interconnected institutions – an extension to its supervision and regulation of all major U.S. commercial and investment banks.
And then for the consumers, who were major victims of financial innovation, Geithner would create a Consumer Financial Protection Agency to consolidate their protection, and to ensure that consumers can understand the risks and rewards associated with products sold directly to them. But Geithner does not want to stop innovation, he wants stronger protections against risk with stronger capital buffers, and greater disclosure so investors.
To improve capacities to manage future crises, he proposes a new resolution authority which would reduce moral hazard. And lastly, to minimize the moral hazard of institutions considered too big or too interconnected, all firms will be required to keep more capital and liquid assets on hand as a greater cushion against losses. The bigger, most interconnected firms will be required to keep even bigger cushions.
Most of these proposals have to be passed by Congress. Geithner will have to cope with the angry right wing which is conducting a big smear campaign against the Obama administration, accusing it of being socialist.
There is already lots of disagreement among Congress members about the proposal to give the Fed new systemic risk powers. Many question the Fed’s competence to discharge this responsibility. Others argue that it is not right for an independent central back to be responsible for managing systemic risk as well as monetary policy. The financial industry is now out in force lobbying the Congress. And even some of the financial regulators are out there fighting for their turf.
Some insightful observers have even noted some of the glaring gaps in the Geithner plan, like a lack of anything substantive on credit rating agencies (with their issuer pay model) or bankers’ compensation – and above all no effective plan for tackling the too big to fail problem.
It seems clear that the end product will be watered down. What’s more, it may take until year’s end or longer for Congress to pass. By then, the recovery will be consolidated, and the pressure for reform will have waned.
Crises can be good opportunities for reform. Indeed, experience shows that historically most good reform experiences have been thanks to good leadership at a moment of crisis. And there is no economy that needs financial sector reform more than the crisis-prone US economy. To quote none other than Larry Summers, the past two decades have seen the 1987 stock market crash, the commercial real estate and Savings and Loan debacle, the LTCM liquidity crisis, the bursting of the NASDAQ bubble and Enron. And US financial institutions had more than a hand in the lending that led to the Latin American debt crisis and the Asian financial crisis.
While there is a grave risk that an early recovery could weaken the pressure to reform, more fundamentally, Washington’s symbiotic relationship with Wall Street may compromise even further attempts to make substantial reforms. In his recent article in the Atlantic magazine, former IMF Chief Economist Simon Johnson recounts a tale of Washington being almost bewitched by Wall Street.
Over the past decade or so, the American financial industry built a kind of cultural capital such that it was increasingly believed that what was good for Wall Street (no longer General Motors) was good for the US. Although the banking-and-securities industry became a major contributor to political campaigns, the problem was more that Washington really believed that the swashbuckling capitalism of Wall Street was in the nation’s interests. This was underpinned by free movement of many, many people like former US Treasury Secretaries Bob Rubin and Hank Paulson between Wall Street and Washington (Geithner and Summers were part of the Rubin team under Clinton).
This had many bad consequences. Over the years, there was a progressive lifting regulations which no longer seemed to be needed, and a reluctance to update regulations in tandem with innovations. And regulators, legislators and academics went soft on Wall Street because they really believed that the banks knew what they were doing!
Ironically, it now seems that big banks are in a stronger political position. As the US government plays the confidence game, no-one wants a major bank failure. So the banks are playing on this, both in the assistance packages they have received, and the influence they are having over regulatory reform.
There is one simple answer, that is, to break the oligarchy by reducing the size of the banks. That would eliminate the too big to fail problem, and also eliminate their disproportionate influence over public policy. As Johnson says “Anything that is too big to fail is too big to exist”.
Financial Regulatory Reform. A New Foundation: Rebuilding Financial Supervision and Regulation. Department of the Treasury. www.ustreas.gov/
“Reflections on Economic Policy in Time of Crisis”, Remarks by Lawrence H. Summers at the 2009 National Conference of the Council on Foreign Relations, June 12, 2009. The Council on Foreign Relations, New York, NY. www.cfr.org
Composite Leading Indicators, OECD, June 2009 update. www.oecd.org
“The Quiet Coup”, by Simon Johnson. The Atlantic. www.theatlantic.com