G7: In Denial and In Need of a Leadership Bailout

By Simon Johnson

The global crisis approaches another major twist in its downward spiral. A key barometer of financial and fiscal pressure - the credit default swap (CDS) spread - has widened sharply for Irish government debt over the past few days; the markets think that the risk of a sovereign default is rising sharply. Immediate action is needed to forestall a dramatic deterioration of growth prospects across Europe and around the world.

The G7 ministers of finance and central bank governors met Saturday in Rome. It was a great opportunity for this group of leading industrial countries to reassert its leadership in the global economy, taking strong preemptive action to prevent a recurrence of the calamitous days and near total financial collapse of September/October 2008.

Instead, all we received officially is a communique that blandly restates what these documents always say: We are opposed to instability and we are working on it, honestly. When an official has nothing to say, he or she talks about “principles” - and this was a pure principles communique (e.g., see their 3rd and 6th paragraphs). Nothing new or even vaguely reassuring.

Unofficially, it appears the situation is even worse. The G7 is signaling a lack of support for various key countries that are in the line of financial market fire. This is irresponsible, short-sighted, and bound to lead us all into great danger.

G7 effectiveness is at a low point. Why? The Europeans are in denial, particularly regarding the way their banks and their broader economic and political elite contributed to the global financial fiasco. The Americans are distracted, to put it mildly, while they search for policies that make sense. There is a great deal of unproductive finger pointing within the G7.

But the real issue is that no one is yet ready to take on the deeper underlying problem - the political power structure of modern finance. While this structure is a particular problem - and particularly obvious right now - in the US, all industrialized countries today share some version of the same problem. We supersized our banking systems, allowed them to load up on risk that could threaten the macroeconomy, and gave them a mindboggling put option - in other words, the taxpayer is on the hook for a vast amount of downside. Across the industrialized (and coming soon to the industrializing) world, the message from bankers is the same: Give us the bailout money, or your economy will suffer.

Coming to terms with this reality and doing something about it will take leadership - the skills, popularity, and vision needed to really take on bankers (and preferably, win). That leadership is unlikely to come from Europe, Japan, or Canada. It’s also unlikely to come from the G20 (which is basically the G7 plus large emerging markets), whose next heads of government meeting is on April 2nd.

Everyone and everything, in some sense, waits for the US and for President Obama. How long will it be before he is able to fully and personally take charge of sorting out banking at home - and help those trying to do the same abroad?

If you see any other - even slight - glimmer of hope in this situation, post it as a comment here.

Comments

[mcadoo3312:]

If you were the Japanese Finance Minister, would you want to be sober?

Feb 17 11:24 AM

[morph366:]

The financial technocracy that got us into the current crisis are absolutely the worst people to solve it. Not only are they in denial but their academic training, culture of cronyism and their intellectual toolkit are not up to the job.
What is required are structural changes to the financial architecture but that cannot happen as long as the focus is one of sticking band aids all over the current system.
Across the board asset write-downs and a legal moratorium on debt repayment covenants would be a good start while a new bi-modal banking system is allowed to develop with public sector funding initiatives to get them started.
One type of bank would be run like like utility companies. Nothing sexy, no corporate jets, relatively predictable income streams and no great surprises when they release their earnings statements.
The regulation of such banks could still fall primarily within the respective jurisdictions where they do most of their business and cross border financing would have to be supervised by an international regulator with supra-national deposit insurance etc.
The other type of bank which would handle what used to be called investment banking should be separated into entirely different entities for those who prefer high risk/possibly high reward investments.
They would be funded by the private sector through the global capital markets and would have to be subject to a new global regulator. The whole labyrinth of offshore tax havens, complex tax treaties would have to be cleaned up and most importantly under no circumstances should the taxpayer ever have to clean up the mess resulting from their inevitable misjudgments.

Feb 17 11:25 AM

[MichaelJ007:]

Political leaders will begin to add further constraints and regulations to the finance, banking, and investment banking industries right after they figure out how to pay for their own campaigns.

Feb 17 11:27 AM

[Nikola:]

I don't know what happened to Obama. Does he feel he's over his head? Seems like it, from the "spiffy new ride" comment the other day.

Feb 17 11:49 AM

[Tom E.:]

The only solution is some type of jail time for bankers who go bust due to over extending themselves. This is the only moral hazzard option left that will have any affect.

Feb 17 12:45 PM

[Jolly_Rancher:]

Excellent idea.


On Feb 17 11:25 AM morph366 wrote:

> The financial technocracy that got us into the current crisis are
> absolutely the worst people to solve it. Not only are they in denial
> but their academic training, culture of cronyism and their intellectual
> toolkit are not up to the job.
> What is required are structural changes to the financial architecture
> but that cannot happen as long as the focus is one of sticking band
> aids all over the current system.
> Across the board asset write-downs and a legal moratorium on debt
> repayment covenants would be a good start while a new bi-modal banking
> system is allowed to develop with public sector funding initiatives
> to get them started.
> One type of bank would be run like like utility companies. Nothing
> sexy, no corporate jets, relatively predictable income streams and
> no great surprises when they release their earnings statements.
>
> The regulation of such banks could still fall primarily within the
> respective jurisdictions where they do most of their business and
> cross border financing would have to be supervised by an international
> regulator with supra-national deposit insurance etc.
> The other type of bank which would handle what used to be called
> investment banking should be separated into entirely different entities
> for those who prefer high risk/possibly high reward investments.
>
> They would be funded by the private sector through the global capital
> markets and would have to be subject to a new global regulator.
> The whole labyrinth of offshore tax havens, complex tax treaties
> would have to be cleaned up and most importantly under no circumstances
> should the taxpayer ever have to clean up the mess resulting from
> their inevitable misjudgments.

Feb 17 01:18 PM

[Simon Smelt:]

Problem is we're not preparing a blueprint but trying to modify a complex mechanism whilst it continues to operate - like trying to do open heart surgery without being able to put the patient on a life support system.
In order to avoid catastrophe in financial and currency markets, the reform will continue to be small and piece meal until catastrophe occurs. Then huge reform will occur virtually overnight - either in pre-prepared form (i..e "they" were just waiting for the opportunitt), or as a direct consequence of catastrophe.

Feb 17 01:47 PM

[JohnL:]

<Immediate action is needed to forestall a dramatic deterioration of growth prospects across Europe and around the world.>

If you prop up a system, and people know it's being propped up, they will lack confidence in the system, they will be reluctant to invest in the system. They will always fear the day the props are removed -- probably because there is no longer public money for them. So, I would think the immediate action needed is to remove all of the props, subsidies and obstructions which prevent the system from finding market-based equilibrium (i.e. relative prices, interest rates, output mix, savings rate, etc.). This will undoubtedly result in new ownership of many assets and liquidation of others, but so be it -- that is how the free market works when it is working best. I just don't see the Pres. Obama showing this type of leadership based on his initial actions.

Feb 17 03:24 PM

[Yohei:]

Geithner and Summers rode to power on Robert Rubin's coat tails. The Obama administration simply could not be more saturated with Big Investment Bank influence. Volcker has been sidelined.

Either Obama is in way over his head or he is in cahoots with the gang that made this mess. Since I don't see how Obama could be as incompetent and clueless as the first alternative implies the second is highly likely.

Feb 17 07:57 PM

[Thomas J. G...:]

I think the Obama camp needs a Rove and they don't have one. The stimulus thing was bungled politically. All they did was spend money. If they had some ideas like re-implement Glass Steagal, even Greenspan was saying to outlaw collaterlizing financial instruments (to keep the risk with the institution that gave the loan), or only using mark to market when there was impairment (someone stop's paying on the loan, the cdo stops paying it's full interest, the company you had stock in goes bankrupt) they should have included that WITH the stimulus bill to show they were trying to address root cause instead of just throwing money at the problem.

Feb 17 10:17 PM

[je:]

All of these comments assume that the current situation is one that no one saw coming. I believe that this entire situation was preplanned and is right on course. Look what has happened to our enemies from this "financial warfare." I think it is going according to "plan."

Think on this for a bit and you might take a different view.

Feb 18 08:39 AM