Obama on CEO Compensation at Too-Big-to-Fail Banks

February 12, 2010 12:15 PM

Bloomberg reports President Obama as commenting on the $17 million bonus for Jamie Dimon of JP Morgan Chase and the $9 million bonus for Lloyd Blankfein of Goldman Sachs with:

"I know both those guys; they are very savvy businessmen,"


"I, like most of the American people, don't begrudge people success or wealth. That is part of the free-market system."

Taken separately, these statements are undeniably true. But put them together in the context of the Bloomberg story—we have to wait for the full text of the interview—and the White House has a major public relations disaster on its hands.

Does the president truly not understand that Dimon and Blankfein run banks that are regarded by policymakers and hence by credit markets as "too big to fail"?

This is the antithesis of a free-market system. Not only were their banks saved by government action in 2008–09 but the overly generous nature of this bailout (details here) means that the playing field is now massively tilted in favor of these banks. (I put this to Gerry Corrigan of Goldman and Barry Zubrow of JP Morgan when we appeared before the Senate Banking Committee last week; there was no effective rejoinder.)

Not only that but the incentive for the people running these megabanks is now to take on reckless amounts of risk. They get the upside (for example: these compensation packages) and when the downside materializes it belongs to taxpayers and everyone who loses a job. (See my testimony to the Senate Budget Committee; there was no disagreement among the witnesses or even across the aisle between senators on this point.)

Being nice to the biggest banks will not save the midterm elections for the Democrats. The banks' campaign contributions will flow increasingly to the Republicans and against any Democrats (and there are precious few) who have fought for real reform.

The president's only political chance is to take on the too-big-to-fail banks directly and clearly. He needs to explain where they came from (answer: the Reagan Revolution gone wrong), how the problem became much worse during the last administration, and how—in credible detail—he will end their reign.

What we have now is not a free market. It is rather one of the most complete (and awful) instances ever of savvy businessmen capturing a state and the minds of the people who run it. Is this really what the president seeks to endorse?

Also posted on Simon Johnson's blog, Baseline Scenario. Following were previously posted:

With Euro Falling, US Recovery is Under Threat

February 7, 2010

Intensified fears over government debt in the eurozone are pushing the euro weaker against the dollar. The G-7 achieved nothing over the weekend, the IMF is stuck on the sidelines, and the Europeans are sitting on their hands at least until a summit on Thursday (February 11). There is a lot of trading time between now and then—and most of it is likely to be spent weakening the euro further.

The United Kingdom also faces serious pressure and there is no telling where this goes next around the world—or how it gets there.

There may be direct effects on the United States, as our banking system remains undercapitalized. Or the effect may be through making it harder to export—impeding one of the few bright spots for the American economy over the past 12 months has been trade. But this is unlikely to hold up as a driver of growth if the euro depreciation continues.

Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner. But this view completely misreads the situation.

The German authorities are happy to have the euro depreciate this far and probably would not mind if it moves another 10 to 20 percent. They are convinced that they must—in fact should—export their way back to acceptable growth levels.

Competitive depreciation is, of course, a no-no in international policy circles. But if your dissolute neighbors—with whom you happen to share a credit union—threaten to implode their debt rollovers and markets react negatively, how can you be held responsible?

Germany and France have no objection to euro depreciation—they are confident that the European Central Bank can prevent this from turning into inflation.

It's the United States that should be concerned about the effect on its exports (and imports; goods from the eurozone become cheaper as the euro falls in value) if the euro moves too far and too fast. But the United States failed to raise the issue with sufficient force at the G-7 finance ministers conclave in Canada and the course is now set—at least until Thursday.

The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill.

And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.

Europe Risks Another Global Depression

February 7, 2010

The entirely pointless G-7 meeting this weekend only served to underline the fact that Europe is again entering a serious economic crisis.

At the end of the meeting, Treasury Secretary Tim Geithner told reporters, "I just want to underscore they made it clear to us, they the European authorities, that they will manage this [the Greek debt crisis] with great care."

But the Europeans are not being careful—and it's not just about Greece any more. Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal. Ireland and Italy are next up for hostile reconsideration by the markets, and the United Kingdom may not be far behind.

What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt—this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay?

The Europeans with deep pockets are doing nothing—except for insisting that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible. This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s.

The International Monetary Fund was created after World War II specifically to prevent such a situation from recurring. The Fund is supposed to lend to countries in trouble, to cushion the blow of crisis. The idea is not to prevent necessary adjustments—for example, in the form of budget deficit reduction—but to spread those out over time, to restore confidence, and to serve as an external seal of approval on a government's credibility.

Dominique Strauss-Kahn, the Managing Director of the IMF, said Thursday on French radio that the Fund stands ready to help Greece. But he knows this is wishful thinking.

  • "Going to the IMF" brings with it a great deal of stigma. European governments are unwilling to take such a step as it could well be their last.
  • The IMF is supposed to provide only "balance of payments" lending. That doesn't fit well when a country is in a currency union such as the euro, which floats freely and does not have a current account issue, and the main problem is just the budget.
  • Greece and the other weak eurozone countries need euro loans, not any other currency. If the IMF lent euros that would be distinctly awkward as this is what the European Central Bank (ECB) is supposed to control.
  • Sending Greece to the IMF would result in some international "burden sharing," as it would be IMF resources—from all its member countries around the world—on the line, rather than just European Union funds. But is the United States really willing to burden share through the IMF? After all, Europe has long refused to confront the trouble in its weaker countries, now known as PIIGS (Portugal, Ireland, Italy, Greece, and Spain). How would the Chinese react if such a proposition came to the IMF?
  • Would the Europeans really want the IMF and its somewhat cumbersome rules to get involved—this would be a huge loss of prestige. It could also lead to some perverse outcomes—you never know what the IMF and the US Treasury (and Larry Summers) will come up with in terms of needed policies (ask Korea about 1997–98: not a good experience). The European Union has handled IMF recent engagement well in Eastern Europe (from the EU perspective), but that was seen as the European Union's backyard. If the eurozone is in trouble, everyone will be paying much more attention—no more sweetheart deals.
  • The IMF gave Eastern Europe amazingly good deals over the past two years (by IMF standards). Would this fly with financial markets in the sense of restoring confidence in the PIIGS and their medium-term fiscal futures?
  • Does the IMF really have enough resources to backstop all the PIIGS? The IMF's notional capital was increased substantially last year, but just based on what we see now the Fund would need even more ready money to tackle the eurozone—all the weaker countries would need at least preventive lending programs and these would need to be large. If that is where this goes, the European Union looks simply awful and has failed at a deep level.
  • The IMF could play a constructive "technical assistance role" alongside the European Commission, but everyone would want to keep this pretty low profile. Anything that goes to the IMF executive board would result in a lot of cheering and jeering from emerging markets. This would break the power of Europe on the international stage—perhaps a good thing, but not at all what the European policy elite is looking for.

The IMF cannot help in any meaningful way. And the stronger EU countries are not willing to help—in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance with strings. Unconditional bailouts are simple—just send a check. Structuring a rescue package that will garner support among the German electorate—whose current and future taxes will be on the line—is considerably more complicated.

The financial markets know all this and last week sharpened their swords. As we move into this week, expect more selling pressure across a wide range of European assets.

As this pressure mounts, we'll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness—and under sufficient pressure, very few government credit ratings will hold up—these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).

Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counterparty risk—the fear that your insurer will fail and this will bring down all connected banks—raises its ugly head again.

In such a situation, investors scramble for the safest assets available—"cash," which actually (and ironically, given our budget woes) means short-term US government securities. It's not that the United States is in good shape or even has anything approaching a credible medium-term fiscal framework. It's just that everyone else is in much worse shape.

Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G-7 (or even G-20) leaders are slow to see the risk. And this time, given that they already used almost all their fiscal bullets, it will be considerably more difficult for governments to respond effectively when they do wake up.

Is Tim Geithner Paying Attention to the Global Economy?

February 6, 2010 (With Peter Boone)

In an interview on ABC, Treasury Secretary Tim Geithner says, "We have much, much lower risk of [a double-dip recession] today than at any time over the last 12 months or so.... We are in an economy that was growing at the rate of almost 6 percent of GDP in the fourth quarter of last year. The most rapid rate in six years. So we are beginning the process of healing."

The timing of this statement is remarkable because while the United States is finally showing some signs of recovery, the global economy is bracing for another major shock—this time coming from the European Union.

The mounting debt and deficit problems in Greece might seem relatively small and faraway to the US Treasury—concerned as it is with China's exchange rate and the ritual of G-7 meetings, and likely distracted by the major snow storm hitting Washington, DC.

But the problems now spreading from Greece to Spain, Portugal, Ireland, and even Italy portend serious trouble ahead for the United States in the second half of this year—particularly because our banks remain in such weak shape.

Greece is a member of the eurozone, the elite club of European nations that share the euro and are supposed to maintain strong enough economic policies. Greece does not control its own currency—this is in the hands of the European Central Bank in Frankfurt. In good times over the past decade, this helped keep Greek interest rates low and growth relatively strong.

But under the economic pressures of the past year, the Greek government budget has slipped into ever greater deficit and investors have increasingly become uncomfortable about the possibility of future default. This impending doom was postponed for a while by the ability of banks—mostly Greek—to use these bonds as collateral for loans from the European Central Bank (so-called "repos").

But from the end of this year, the ECB will no longer accept bonds rated below A by major ratings agencies—and Greek government debt no longer falls into this category. The market can do this kind of math in about 20 seconds: If the ECB won't, indirectly, lend to the Greek government, then interest rates will go up in the future; in anticipation of this, interest rates should go up now.

That is trouble enough for an economy like Greece—or any of the weaker eurozone countries that have been known for some time and not in an endearing way as the "PIIGS." But paying higher interest rates on government debt also implies a worsening of the budget; this is exactly the sort of debt dynamics that used to get countries like Brazil into big trouble.

The right approach would be to promise credible budget tightening down the road and to obtain sufficient resources—from within the eurozone (the IMF is irrelevant in the case of such a currency union)—to tide the country over in the interim.

But the Germans have decided to play hardball with their weaker and—it must be said—somewhat annoying neighbors. As we entered the weekend, markets rallied on the expectation that there might be a bailout for Greece (and all the others under pressure). But, honestly, this seems unlikely. The Germans hate bailouts—unless it's their own banks and auto companies on the line. And the European policy elite love rules; in this kind of situation, their political process will grind on at a late 20th century pace.

In contrast, markets now move at a 21st century global network pace. This is a full-scale speculative attack on sovereign credits in the eurozone. Brought on by weak fundamentals—it's the budget deficit, stupid—such attacks take on a life of their own. Remember the spread of pressure from Thailand to Malaysia and Indonesia, and then the big jump to Korea all in the space of two months during fall 1997.

Tim Geithner and the White House may feel they must stand aloof, waiting for the Europeans to get their act together. This is a mistake—the need for US leadership has never been greater, particularly as our banks are really not in good enough shape to withstand a major international adverse event (e.g., Greece defaults, Greece leaves the eurozone, Germany leaves the eurozone, etc.).

Yes, we subjected our banks to a stress test in spring 2009—but the stress scenario was mild and more appropriate as a baseline. Many of our banks—big, medium, and small—simply do not have enough capital to withstand further serious losses (think commercial real estate).

As the international situation deteriorates—or even if it remains at this level of volatility—banks will hunker down and credit conditions will tighten around the United States.

And if the European situation spins seriously out of control, as it may well do early next week, the likelihood of a double-dip recession (or significant slowdown in the second half of 2010) increases dramatically.

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