Simon Johnson on Eurozone Woes and the TBTF Regime

We had the opportunity this week to catch up with Simon Johnson on Benzinga Radio. He is the former chief economist at the International Monetary Fund, where he worked in 2007 and 2008 during the global financial crisis, and author of the book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Currently, he is the Ronald A. Kurtz Professor of Entrepreneurship at the MIT Sloan School of Management. On what he is doing this semester at MIT:

Simon Johnson: I am teaching two very different classes. One is on global macroeconomics, including various crises all around the world. The other is on entrepreneurship around the world where students go to work with people--particularly in emerging markets--who are running small or medium sized companies that have been very successful and want some outside help. The macro can be a bit depressing. It's very encouraging to work with entrepreneurs, I find. It gets your spirits up. They are both MBA classes at the Sloan School of Management at MIT. The students are very strong. I think this part of the American economy--our ability to attract talent, develop talent at the top end, people who want to build companies and become effective managers--this part is fine. It's other parts of the American economy--other kinds of jobs and skills development--that I think are more problematic.

On whether he thinks "minds are becoming more concentrated" as a result of current pan-Atlantic crises:

Simon Johnson: Not in any productive way. Obviously, the political debate in the United States has moved on, but it's moved on into a space where the implications of all the shouting around the budget and so on are further undermining confidence. Minds are not clearly concentrated right now. I think Asia has done better than I expected, or worried, in that piece, but Europe has done worse. Who would have imagined that Europe would get a full-blown sovereign debt crisis across the whole spread of the eurozone? It's bad, and it's not getting any better soon. I think there are plenty of good ideas out there. I don't see a process through which they get distilled into policy or get close to being implemented. I spend quite a lot of time talking to people, particularly on Capitol Hill, who are interested in trying to do something constructive around jobs and around moving forward in a way that a lot of Americans can participate in whatever growth we get. I don't feel we are making a lot of progress there. I wouldn't say I'm discouraged, but I don't see progress that I can report to you.

On the European sovereign debt crisis:

Simon Johnson: Whatever you think about American banks and American banking policy, what they have in Europe is worse, including on all of the dimensions that you just highlighted. Greece does have a default. I don't know why people refuse to use this term. They are going to restructure their debt. The banks will end up with downside protection of 33 cents on the dollar, but that's a big reduction if you bought at par. We don't know exactly how that is going to spill over and affect banks, either directly through their holdings of Greek debt, or indirectly, when you reprice the risk inherent in the minds of investors now in Spain, or Italy, or France, or anywhere else. The banks are absolutely a very weak link in the global economy--European banks. The ability of the Europeans to act decisively in this crisis and to use their remaining fiscal firepower--their balance sheets and their monetary credibility to stabilize the situation--that ability is in question. The U.S. had some very muddled moments, including when the TARP legislation failed in the House of Representatives in early October [2008], including when Hank Paulson said he was going to do one thing as Secretary of the Treasury and then did another thing with regard to how that money was used to stabilize the situation at the banks. The European situation is incredibly complex, all of these different governments involved. The Germans are digging in, not wanting to hand out additional assistance. At the same time, countries like Greece want a better deal, and countries like Italy feel that there could be something in this for them, too. The political economy dimensions are very tricky to keep track of, even for insiders.

On Bank of America's and other banks' efforts to reduce assets and raise capital:

Simon Johnson: No, it's not enough. I think Bank of America has become too big to manage. It needs to be broken up. The kinds of measures they've taken are stopgap, and repainting the deck chairs on the Titanic, in my assessment. SocGen is really about government support. The entire story in Europe is which governments are willing to support their banks, or who gets supported, which governments can provide support, and how you feel about the impact on the government balance sheet of taking on additional obligations through the support provided to the banking system. We'll see how the French government plays its cards vis-a-vis SocGen, but I think it's entirely a sovereign risk assessment at the moment there.

On the ECB's ability to prevent a flash crisis in Europe:

Simon Johnson: The European Central Bank has indicated that it will provide liquidity to banks. It will also buy up a lot of government bonds--it bought up a lot of Italian bonds, Spanish bonds, and so on. The Germans are very uncomfortable with this approach, and the approach does have risks. The ECB is taking a lot of credit risk, there are potential monetary and inflation implications if they can't fully sterilize buying Italian bonds. This is a big part of why I think Jurgen Stark resigned from ECB management last week. Of course, he was quickly replaced by somebody else who is just as hardline, and perhaps will be more hardline--another German. This confrontation between the leading powers and schools of thought around monetary policy in Europe is going to continue. You should expect, at best, a great deal of instability. Probably, some bad things are going to happen before the Europeans decide to put their differences behind them and figure out who is going to bear what fiscal cost. I think the situation will be stabilized when the Germans reach an agreement, an accommodation with other weaker countries on the basis of who bears what costs, who can run what kind of fiscal policy going forward. I don't know where in the space between an extreme German position and an extreme Greek or Italian position that compromise is exactly going to be forged. They don't know, and they are going to fight hard before they decide that.

On Christine Lagarde's comments about mandatory bank recapitalizations and whether more bailouts in Europe are off the table:

Simon Johnson: I don't think anything is off the table. The big constraint, I would say, is German politics, German public opinion. Not so much legal challenges, although those might play some sort of tactical role in events as they unfold. The big issue is what German voters think needs to be done, what they think is a fair cost to them, to what extent that can be sold to them by German politicians--and there are a lot of things to be worked out there.

On just how exposed to a Greek default the banking system might really be:

Simon Johnson: Based on what we see in the public domain, at the moment, the impact should be fairly limited. I'd worry more about the problems at Bank of America, I'd worry more about continuing fallout from the mortgage disaster in all its dimensions. I don't think the Europeans can let a big bank fail. I think they will provide a lot of liquidity or other support to those banks as needed. That opens up a lot of problems down the road, perhaps, for them. It encourages moral hazard, for sure, around the world. It doesn't disrupt U.S. banking in an immediate way. Of course, that could just be wishful thinking on my part.

More on Bank of America's recent paring activities:

Simon Johnson: They should pursue more dramatic measures. By my reckoning, we're talking about a 6-10% cut at Bank of America in headline kinds of numbers, including employment. That is not very dramatic, and this bank is still extremely unwieldy and has proven in the past to be somewhat out of control. I don't think the current management will want to make them much smaller. Management likes size. There are lots of private benefits to running a big bank. The social dimensions--the impact on the rest of us--are not so good. The FDIC--working with the Fed in the first instance, but also involving the Treasury and the Financial Stability Oversight Council--has a responsibility to take more preemptive action with regard to mega-banks if they feel those banks pose a risk to the system. I think Bank of America is headed very much in that direction. I, for one, strongly encourage the FDIC to get out ahead of it and don't wait until Bank of America needs some sort of emergency assistance for whatever reason. Be proactive, break it up, figure out which parts can be saved, and how. Figure out what kinds of losses need to be absorbed and think about how to absorb them.

On the possibility of a resurgence in credit growth going forward:

Simon Johnson: I don't think most of the banks are close to failing. I think, though, credit is going to increasingly become a constraint on the recovery. The banks don't have enough capital. They don't have enough equity funding relative to their debt. They are worried about potential losses…and they are going to be careful. At the moment, obviously, demand for credit is limited. Credit-worthy companies and credit-worthy people are not that inclined to borrow, but assuming the economy gets going, then there is going to be demand for credit. Are banks, big, medium, and small, in a position to provide that credit in a responsible and timely manner? I don't think so, not based on what we see right now, but I don't think the policymakers are going to want to move at all preemptively, particularly in this political climate. It's kind of a hands-off moment. We'll see what we get, and I'm not optimistic on that dimension.

On how an economy dependent on financialization can cope without it:

Simon Johnson: The ideal alternative would be for the private sector to find other investment opportunities, other attractive rates of return adjusted for risk, and to have a private-led investment boom in that direction. That does not seem to really be happening, although some parts of the private economy are doing quite well, for example, globally operating companies, but even they are not really hiring--it doesn't come with the job growth. That's a problem. The less-good way to do that transition, of course, would be for the financial sector to shrivel gradually in this Bank of America type of manner without jobs being created in other parts of the economy to really compensate for that. I fear that's the trajectory we are on. If you look at GDP per capita in real terms, adjusted for inflation, at the end of the second quarter of 2011, it was just below where we were at the end of the second quarter of 2005. In other words, we've lost more than half a decade of growth. You don't lose decades--Japan went and lost its decade in the 1990s--it wasn't obvious to people who were in it that they were losing a decade. It was, "we grow, we slow, we grow, we slow." Lost decades are lost, or understood to have been lost, only in retrospect. That, I fear, could be where we are headed.

On whether financialization is gone for a while or if it will return:

Simon Johnson: I think lots of people got burned. Lots of companies and lots of individuals feel that bad things happened when credit dried up in the fall of 2008 and they want to be careful about borrowing too much. That caution, added up over the whole economy, means less demand for credit, even if the economy recovers. In principle, you could refinance your mortgage fairly easily and at lower rates right now. A lot of people choose not to do it. Maybe they have issues with their credit score. Maybe they are refinancing, but reducing the amount that they borrow. There is certainly not a boom in the volume of lending to households through refinancing. So, for whatever reason, I'm skeptical that finance will provide the kind of driver to growth and the kind of jobs that it provided over the past few decades. Now, to the extent that parts of finance--but I would stress, only parts of finance--were based on this "too big to fail" premise and the implicit guarantee that comes with that, I don't think we should cry too many tears. If Bank of America becomes smaller, or becomes "small enough to fail," I think that's good for competition, it's good for efficiency, and it's great for the American taxpayer and for the longer term health of the American economy. You do need some other part of the economy to take off. Something needs to boom and we need investment in something productive. I'm looking at the private sector--I'm talking to CEOs and I'm asking them where they are going--and they have no clue. That's not encouraging.

On the broader issue of real wage growth vs. productivity growth and income inequality in the United States:

Simon Johnson: The lack of real wage growth and the widening inequality and squeezing of the middle class--those are real phenomena, and they are very serious and longstanding. I don't think that is what drove the financial crisis. It was much more about the failure of financial regulation. It was about big firms wanting to take on crazy risk and actually being payed very well when they did that. The lack of good jobs and our inability to generate middle-class jobs is a huge issue that needs to be addressed, but I personally think putting that together with the financial crisis just confounds and confuses people a bit. I would rather see these as different and separable issues. I don't think those are inconsistent; my argument is just the main driver was the motives of people in the financial sector and their ability to take on big risks that they didn't manage well and didn't even measure well. A lot of the financial crisis is about relatively poor people trying to get into houses that they couldn't afford. A lot of it is about, you might say, surprisingly well-off people taking on mortgages that they didn't fully understand, and then derivatives being piled up on top of that and a financial structure being traded that was fragile, that couldn't withstand the shocks from a normal economic slowdown, let alone a serious recession.

On the political climate in the United States:

Simon Johnson: I think there is going to be a lot of extreme language, and I'm worried that some of that will undermine confidence. You don't see any bipartisan consensus behind a set of policies that would make any kind of difference. We will see what gets resolved, if anything, by the 2012 presidential election. No consensus, and that's a problem because the economy is not moving ahead strongly, of its own accord. The U.S. is a big, diverse country, and it should be able to bounce back. I think, left to its own devices, next year should be better than this. The Europeans are a big wild card. Their sovereign debt crisis is out of control. They refuse to deal with it in a clear and convincing manner. That is really going to cloud the picture for the next 18 months.

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