The Economics of Vilification

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Includes: AIG, GS
by: The Baseline Scenario

By Simon Johnson

CEOs of major banks have started to push back against the critics - their primary job, after all, is lobbying (rather than, say, risk management). As such, they are typically sophisticated communicators who use a wide range of symbols, words, and modes of communication to get their points across.

Not everything they say, of course, should be overinterpreted. For example, calling the hand that feeds the banks “asinine” (Richard Kovacevich, chair of Wells Fargo) seems more like an outburst than a promising way to enhance shareholder value - even if he is correct about whether today’s stress tests are actually meaningful.

Lloyd Blankfein’s February FT op ed famously made the case that we need banks as a “catalyst of risk.” But this argument raises awkward questions. What does Goldman Sachs (NYSE:GS) know about risk, and when did it learn this (presumably recently, after they settled up with AIG)? My risk-taking entrepreneurial contacts feel their catalysts should be somewhat smaller relative to the economy - so these banks/securities underwriters can, from time to time, go bankrupt without threatening the rest of the private sector (and everyone else) with ruin. Still, the main point of this FT article was the symbolism of the timing, appearing on the morning of what was scheduled to be Secretary Geithner’s first big speech; we were supposed to read Mr. Blankfein’s conceptual script, then look up and see the Secretary on TV.

Vikram Pandit’s recent letter to Citi employees was a nicely timed communication to his broader social and political audience. His upbeat note was plausible because he put down some very specific markers, e.g., “best quarter-to-date since 1997″; the danger is that these come back to haunt him. And as a document making the case for big banks more generally, it was weak.

The banking industry’s thought leader right now is definitely Jamie Dimon. His point about vilification is straightforward.

Dimon gently points out that unless we stop vilifying corporate leaders (and presumably he would say the same of traders this week), we will not get an economic recovery.

And, at some level, he must be right. If you create enough uncertainty around the future rewards for any activity, e.g., trading securities, setting up new companies, or fishing, you can easily get less investment of time and effort in that activity. You may also, of course, get more speculative behavior as time horizons become shorter - i.e., “take the money and run” becomes more attractive relative to building up a reputation for good behavior.

“We are where we are,” is something I’ve heard (in other contexts) from people with authority who have screwed up very badly but who know that everyone wants and needs to move on.

But the reality in banking is somewhat more complicated, for three reasons.

1. We don’t know how much of banking profits in recent years were illusory and should not have been booked as GDP. In fact, it would not be a big surprise if - eventually - we go back and mark down our true production of goods and services in 2007 by 2 or even 5 percent. In this sense, we face a statistical situation similar to that of the Soviet Union at its demise - once they figured out that all their military production had no real value, they had to reduce measured GDP sharply. It is not compelling to say we should necessarily go back to where we were in banking.

2. Clean-ups in banking and most other activities require bringing in new people. But, as the AIG discussion over the past week has made clear, much of the finance industry has not yet reached the point where they see this as essential. This is about good housekeeping, not vilification.

3. Going forward, Mr Dimon concedes that being Too Big To Fail is bad, but he does not apparently see the logical consequences. Not all bankers made business-ending types of mistakes, but some did and under our current business-as-usual course, we will end up with fewer big players. Mr Dimon proposes changing something (vague) about regulation and bankruptcy so that the taxpayer need not be afraid of the new behemoths failing. But this cannot possibly be plausible, after all today’s problems are largely the result of weakly enforced regulation and politically powerful banks; in the future this imbalance will worsen.

There may well be short-run costs (i.e., in ways that really hurt: lower growth, more unemployment) to properly cleaning up and restructuring the banking system. The exact size of these costs is hard to know, but we should face reality on this point - there is a potential tradeoff between presumed costs of bank reform today and longer-run improvements in our sustainable growth potential.

But the real question is bigger. Can we continue to live with the risks involved in having banks that are large relative to GDP and politically very powerful? Banks of that size cannot commit not to screw up. In fact, the people who work for them will know - based on what they have seen so far - that even if future bailouts do not ultimately save the business, one way or another, they will walk away with a lot of stuff.

Tell me if you perceive an alternative, but I can’t see any sensible way forward that does not involve breaking up large banks and making sure they stay much smaller relative to GDP. This is surely not sufficient for stability and prosperity in the future, but right now it appears unavoidably necessary.