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[Music] We're speaking today with Simon Johnson, who's a professor at MIT and also a
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former chief economist at the International Monetary Fund and the author of 13 bankers, The Wall Street
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Takeover and the Next Financial Meltdown. Welcome. Thanks for having me. In your book,
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which was written before the recent financial legislation was passed, you have a sentence in there that's
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predictive and it says, "It's likely our government will use this legislative
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cycle to declare victory over the financial crisis without addressing its most fundamental cause." Is is that
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what's happened in your view? I'm I'm afraid so. Yes. The book was finished in January of this year. The
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legislation obviously was debated most intensely in the Senate in March and April and it passed in the summer. There
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were some steps in the right direction. This is the DoddFrank financial reform uh act and some steps that that I
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definitely support, but it's not enough. It doesn't really address the fundamental causes. I think the
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financial system, if anything, is becoming more dangerous than it was even before 2008.
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Could you tell us what were the the positive points in the bill, just a brief summary of your views and what
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what the big gaps were? Well, the big positive was obviously consumer protection and the fact the president
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has now put Elizabeth Warren in charge of figuring out how to implement and how to build an agency as mandated by by the
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statute that that's that's terrific. That's exactly what we needed. But in
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terms of system risk, in terms of making the biggest banks less risky, in terms of reducing the kinds of
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interconnections that almost brought down the world's financial system at the
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end of 2008 and early 2009, the legislation makes very little progress, if any, in the right direction there.
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Of course, proponents would say that it it did make progress and that um it has ended the worries about too big to fail.
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You obviously disagree. Can you tell us specifically why you disagree? The heart of the argument
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on behalf of the DoddFrank legislation with regard to too big to fail is that there is now a resolution authority and
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a resolution mechanism so that the FDIC on behalf of the government can take over shut down manage the failure of any
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kind of financial institution. Previously they could do it for depository institutions in well
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institutions banks with insured FDIC insured deposits. Now in principle they can do it for everyone but they can't
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because our largest banks are global banks and there is no crossber bank resolution failure mechanism nor is the
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G20 taking up the issue of how to construct one nor do any of our major trading partners want to have such a
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mechanism. So if Croup hypothetically were to fail, Cityroup operates in in more than 100 countries, how would you
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manage that? What would the FDI do? What's the mechanism for the failure for
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losses to be faced by creditors? And the answer is if you if you take this up directly face to face off the record
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with senior administration officials, they'll concede the point. They'll say,
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"Well, actually, we we would do um we would we would support the institution.
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we'd have to um we'd have to do a conservatorship. Conservatorship is a bailout.
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Conservatorship is protecting the creditors. That's not a resolution mechanism. And the creditors know this.
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So the big banks, the global banks, the ones at the heart of the previous crisis, are invulnerable from the in the
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sense that their creditors cannot face losses. So without a global mechanism really the United States, however
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well-intentioned, would be unable to protect against banks that are too big to fail because they could crash the
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system ultimately. And so does that mean that bankers today are back again to being confident that they can take on
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what I think you call in your book many times uh excessive risk um and uh that the public will will take care of any
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downside and they'll be able to skim off the upside which is what the perception
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is that happened last time. Yes, that's exactly where they are. Of course, there's a cycle and right after
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a major financial crisis you're going to be somewhat careful. That's understandable and that's why you don't
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see back-to-back global financial crisis, not year in year out. But over time, as we go through this cycle, we're
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going to have the same sort of risk-taking. Jaime Diamond says you have financial crisis every 3 to seven years.
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Hank Pollson says it's four to eight years. Larry Summers says uh four to nine years. Doesn't matter. These big
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guys agree and they're right that you'd do it again because the system of
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incentives and the structure of these organizations is essentially unchanged. So then the question starts to be what
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what could what else might be done about that? And um you quote Alan Greenspan of
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all people in your book saying that uh if they're too big to fail then they're
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too big. And uh he goes on to say in his prescription and this was just about a year ago so not all that long ago. Break
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them up. In 1911 we broke up standard oil. So what happened? The individual parts became more valuable than the
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whole. Maybe that's what we need. Um, and I know that this is what you advocate in your book to some degree.
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Break them up in the sense of reduce their size. So, could you talk about how that would work? I know you talk about
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size limits and you have some ideas and mechanisms on what that would look like.
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Yeah, absolutely. This is the heart of the matter. And in addition to Alan Greenspan, I'm now citing Gene Farmer,
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the the the father of modern finance, the person really behind the idea of efficient markets in finance, who said
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on CNBC recently after we finished the book, he said, "Too big to fail is an
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abomination. It's not a market. It's a government subsidy scheme and it should
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be ended." And the best way to end it is to update and apply the Regal Neil Act
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of 1994. Regal Neil sets a size cap on our largest banks as a share of retail deposits. No bank can have more than 10%
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of total retail deposits. The idea that was proposed as an amendment to DoddFrank by Senators Brown, Sheriff
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Brown and Senator Ted Calfman was that there be a hard size cap in terms of the size of bank relative to the US economy.
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You can relative to GDP. Exactly. Relative to GDP so that nobody can no individual bank can become big relative
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to your economy. Now we can discuss where that limit should be drawn. I would definitely be in favor of a much
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lower limit. Um, we can put a dollar number on it if you like, but that basic idea of a hard
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size cap beyond which you cannot go, I think is is what you need in in the American situation.
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I think in your book when you were talking about what that level should be, you said something that would be akin to
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where banks were in size in the mid 90s or so. So, we're not talking about we're
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not talking about draconian reductions. Absolutely. So Goldman Sachs um in the late 1990s was about a $200 billion
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bank. Let's call it $250 billion in today's money. Before the crisis in 2008, their balance sheet peaked at 1.1
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trillion. Now what did the US economy as a whole, what did the financial system even gain from that big increase in size
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of Goldman Sachs? Nothing. No one can point to any economies of scale or scope or other benefits from increasing size
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above actually above about $50 billion in total assets. So there were lots of benefits for sure private benefits for
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Goldman Sachs. The CEO gets more compensation definitely CEO by the way in this period of rapid growth was Hank
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Pollson who later became secretary of the treasury. But if you go back, if you we you've asked or forced Goldman Sachs
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and banks like that to go back down to the days where there are 200 billion or maybe we even end up with a hundred
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billion as as the hard cap. Um what's the damage? What do you lose from that
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in terms of either the functioning of the American economy or the functioning of the global financial system? And the
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answer from all the experts I've talked to, both academic and and practical people really in the business, the
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answer is you wouldn't lose anything. You don't remove system risk completely.
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Of course, there is no magic bullet. these measures we're proposing are surely not sufficient to reduce
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financial system risk. We're just arguing that they're necessary and and
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also that they haven't been taken. The other interesting stat in the book, I
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think I've seen this elsewhere also, was I think it's the percentage of corporate
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profits that the financial industry represents, and um I might have this a little off, but I think this is roughly
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right that up through maybe the beginning or middle of the 80s or maybe even a little bit later, um the most the
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financial system ever took up in total corporate profits in the US was about 15% or so. By uh just prior to the
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crash, it was up to 41%. In other words, the financial services industry was earning 41% of all profits in the US.
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Um, that was that that's something that we never even got close to in the past
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that suggests that that maybe something was out of whack. Why didn't anybody see
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that? Well, I know some people did, but what and where are we now? And how long do you think it it might take before we
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get back up to that? According to your view, what's likely to happen? Well, we're heading back into similar
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territory. the financial sector profits are are strong and I I think they're
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going to uh really do well partly because there's fewer of them. There's
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less competition, there's more market power in this area. But you're absolutely right, it's a it's a wakeup
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call because those are not real profits. Those are not riskadjusted profits. Those are not profits if you go back and
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state them against the losses that were incurred because a lot of those losses were transferred to the taxpayer.
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Larry Summers says that 40% financial sector profits at 40% of total corporate profits is a warning sign and we should
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have taken it as such. And he's absolutely right. When you show those numbers to the CEOs of non-financial
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companies, they're staggered actually and quite shocked and and so they should
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be, but they won't do anything about it. They won't even participate in criticism
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of the financial sector. they've actually closed ranks protecting the biggest banks and that's very dangerous
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for them individually for their companies and for all the people who who work for them because this is the big
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risk facing the United States going forward. The other thing that's that's
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interesting uh and and you talk about a number of different problems with too big to fail such as um taxpayers end up
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on the hook for all the money. But also this idea that because it the backup the
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backs stop the the implicit guarantee the moral hazard is is is basically there but only for the very largest
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banks that the next tier down say large regionals and so forth. They're actually
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put at an unfair disadvantage competitively because they don't have that subsidy and therefore they you know
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they can't operate in the same way and you know it's not a level playing field
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and yet we don't see too much opposition from them either. You just talked about
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the corporate sector in general. What's going on here? That's a very interesting question and
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you should pose it to the bankers themselves. I I don't think I can speak on their behalf, but I but I think we I
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I would certainly agree and underline there is a big divergence in interest between the massive the mega banks, the
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mega global banks that have this implicit government guarantee now and therefore a lower cost of funding and
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the banks they compete against in many markets, including the mid-size banks and and the community banks. It's not
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fair. It's it's it's a government subsidy scheme that's not fair. not
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transparent and very dangerous. But the US corporate leadership unfortunately feels they should stick together in
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situations like this. The Chamber of Commerce uh has certainly spoken out uh consistently on behalf of the big banks
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and and saying claiming to speak on behalf of small business. It has opposed um almost all of the sensible provisions
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of the DoddFrank Financial Reform Act. I I find this extraordinary and and disconcerting and I spend a lot of time
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I'm a professor of entrepreneurship at MIT among other things. I talk to a lot
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of business people. I work with entrepreneurs in the US and around the world. I spent a lot of time with them
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on on these issues and I think over time that their their view will change. But it is unfortunate and and it definitely
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affected the political process in this goound that the business sector the non-financial business sector didn't get
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it. They don't understand how much they and their families and their people have
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been damaged by the irresponsible, reckless, unnecessary behavior of the big banks.
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Given that um that you don't think that that the latest round of financial reform has has done the trick, um let me
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just turn to something else that you say in your book. We face the prospect of a
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1920 style roller coaster. um meaning the economic cycle will be more volatile I believe. And then and then you say uh
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this is a recipe not for stagnation but for a metaboom in which we will receive warnings including painful recessions
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but consistently ignore them. And one last thing in the the 1920s opened with an 18-month re uh recession, an eerie
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parallel to the 2007209 experience. It ended with the great crash of 1929. So, not that we want to be talking about
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depression necessarily, but I think you want to talk about volatility and and certainly recession such as we have now.
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Or maybe you do want to talk about the I want to emphasize that too big to fail is not the worst of our problems. I
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actually had this conversation with with a leading banker, a gentleman with a great deal of international experience
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recently and he said, well, look, too big to fail is part of the scenery. Now, you just got to deal with it. Now, I
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agree on a tactical level that is actually correct. I don't think there is anything on the table or or waiting in
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in the wings that will make any difference to the rising power and the dangers posed by these big banks. But
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too big to fail is not the worst of our potential problems. Be too big to save. Think about Ireland.
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Too big to bail. Absolutely. Ireland allowed its three largest banks to build up total assets
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two times the size of the Irish economy and then they failed. The Irish government issued a guarantee
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that at least as we speak today covers all the liabilities of those banks. They turned a financial banking
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sector problem into a fiscal issue and in my view and this is something we write about on our website and we go
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through the analysis. In my view and and I certainly disagree quite strongly with
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the views coming out of the official sector but I would point that the market point out the market is moving in in my
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direction on this issue. My my point is that um Ireland can't afford the bailouts they've taken on. It's not
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fiscally sustainable. So, it's kicking the can down the road. Well, it's trying to kick the can down
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the road. Trying to kick the can, but it's not moving. The can's too big.
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Mhm. Right. You're going to break your foot. You're looking at a fiscal disaster.
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You're looking at a sovereign debt issue. And I and I think we must take this
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seriously for the United States. When will will that actually hit the wall though? Because I say kick the can
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down the road in the sense that that there there's no there's no panic. There's no strong reaction. There was a
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strong reaction and then certain steps were taken. Uh, and maybe we can talk about that because I know also in in
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that blog piece, um, you talked about perhaps one way out for Europe is, uh, to issue some form of Brady bonds, which
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were used to help bail out Latin America, which I think essentially just spread the debt out over a long period.
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Is that right? Is that is that was that the main mechanism that allowed them to work? And and you're recommending those
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uh to be used in Europe as well? Well, what what helped Latin America at the end at the end of the very difficult and
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and and essentially lost decade of the 1980s was that they restructured their debt. They were allowed to extend their
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payments reducing the debt burden reducing the cash and there was a let's say regulatory compromise reached
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including the Brady bonds that allowed the banks not to mark down their debt so much. So this is how they squared the
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circle of not wanting to recognize the losses among the lenders and letting the borrowers
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get somewhat off the hook. So it's a forgiveness of debt a little bit without
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it being recognized. So it's sort of accounting. It's how you forgive the debt in a in in
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a situation where you don't want to look like you're forgiving the debt. So
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something like that um for Ireland and and maybe for other Europe Euro zone countries I think should definitely be
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considered seriously. It is unfortunate that the official sector never wants to consider such options until it's too
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late until they have to scramble until they have to do things in a manic rush over a weekend. I think now is the time
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to prepare for that kind of sovereign debt restructuring. And as we look forward, I would emphasize that while
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the moral hazard in and around the big banks is absolutely huge and will be a major problem that we face resolving
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that looking at the implications moral hazard around lending to governments, governments that are regarded as safe
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will also be an issue. Can we just define moral hazard for folks that are watching so we can be
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they can be clear about what it Oh, moral hazard is very simply that when I give you insurance, you're going to be a
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little bit less careful. And if you go back to the, it's interesting, you go
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back to the foundation of the Federal Reserve, 1913, quite late for the formation of a modern central bank
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compared to other countries comparable to the United States. There was a big debate about this issue because the
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bankers said, "We want protection. We the financial markets have gone too big,
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too complex. We can't support ourselves." This is what they learned in the crisis of 1907. We need the
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government to be involved. In fact, the government had put in a big amount of cash in 1907 to save some of the private
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banks. And the debate was, okay, you the bankers want support. That's fine. Nobody wants a global or or even
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national financial collapse, but there has to be a quid proquo. We need some oversight. We need some regulation or
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what we now call regulation supervision. So, that's the essence of the moral
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hazard problem. But unfortunately, it's hasn't worked. It worked. It didn't work
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by the way in the 1920s either. That's why you got a runaway boom. That's you
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know the banks went crazy in terms of taking risk and keeping risk on their own balance sheet. That's why we got the
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reforms of the 1930s and those worked for about 50 years and then they were systematically carefully with a great
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deal of forethought dismantled. Well, that's what why we got the crisis of 2008. We did not though go out and
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rebuild the modern equivalent of those constraints that were put up in the 1930s. The DoddFrank bill doesn't do
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that. And therefore, we still have the same problem that we had prior to 2008 and in the 1920s.
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So that's the that's the um the metaboom cycle that you're talking about.
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Yes, that that's my as a parallel. That's that's my baseline scenario. We
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call our website baseline scenario, meaning we have a baseline view. We move it from time to time, but as we speak
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today, that is my baseline view. And since we touched on Europe, could you give your view of the Bessel 3 Accords
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as which is the European uh the latest European financial legislation or reforms and uh maybe draw some parallels
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between that and what was done in the US? Well, the Basel 3 is is a is a global agreement. There's 27 countries on the
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Basel committee and they agree on a lot of things around bank regulation with first and foremost issue being bank
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capital. And the problem at Barcel 3 is that while the US does want somewhat higher required capital in banks, the
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Europeans don't and actually the Japanese don't. Um and as a result, we end up with a compromise which is what
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people often call least common denominator and which in in common English you could say not enough. So the
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capital required at the end of the day when you make all the adjustments by Basel 3 will be about 10% tier one
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capital. That's roughly what the US banks have had for the past two decades.
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So there's no change in required capital relative to what US pinging practice has
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been. But it will help Europe in some way presumably if they follow the rules. Unfortunately,
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they have a track record of providing many exemptions and exceptions to their most privileged banks.