Baseline Scenario: The Book
By Arnold Kling
Simon Johnson and James Kwak call it 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. It is one of the most valuable contributions to the literature on the financial crisis.
Of all the economists, journalists, and pundits who have written on the financial crisis, Johnson and Kwak are the ones who most strongly emphasize the political dimension of financial regulation. They see large financial institutions as capable of creating a political juggernaut. Hence, their main policy proposal is to break up large banks. As you know, I have been brought around to their point of view, which has been articulated on their blog.Johnson and Kwak start by putting the issue of large banks in historical and international context. Although they lean left, they may shock progressives with their sympathetic treatment of Thomas Jefferson and Andrew Jackson in their suspicion of financial concentration.
Johnson and Kwak even depart from the usual progressive narrative in which the Federal Reserve was the creation of forward-thinking experts seeking to modernize the U.S. financial system. Instead, they tell more of a bootleggers and baptists story. p. 27:
Nelson Aldrich represented the viewpoint of the banking industry…Aldrich was the chair of the National Monetary Commission…which recommended the creation of a central banking system largely controlled by the private bankers themselves…What these bankers wanted was a bailout mechanism that would protect the financial system in the event of a speculative crash…They knew that a new central bank would need the political backing and financial support of the federal government, but at the same time they wanted to minimize government interference, oversight, or control.
The next chapter looks at the political economy of banking from an international perspective. Johnson’s experience with the International Monetary Fund acquainted him with political-financial oligarchy as it has evolved in many other countries, particularly those in emerging markets. This provides him a lens through which to view our recent experience. He sees a “this time is different” level of complacency among U.S. policy makers. The mindset is described on p. 55:
Two of the crucial ingredients–tight connections between economic and political elites and dependence on fickle short-term flows of foreign capital–seemed completely out of the picture…In countries that had already “emerged,” like the United States, economic questions could be studied without reference to politics. Instead, economic and financial policy presented only technocratic questions…
Next, Johnson and Kwak offer chapters that tell the story of the growth and concentration of finance in the United States from the 1980’s until today. p. 59-60:
most of the growth in the financial sector was due to the increasing “financialization” of the economy–the transformation of one dollar of lending to the real economy into many dollars of financial transactions. In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the real economy; by 2007, that had grown to $51.
Again, they tell a story that intertwines politics with economics. They view deregulation as a development that (p.64-65)
emerged from a confluence of factors: exogenous events, such as the high inflation of the 1970s; the emergence of academic finance; and the broader deregulatory trend begun in the administration of Jimmy Carter but transformed into a crusade by Ronald Reagan. The eventual result was an out-of-balance financial system that still enjoyed the backing of the federal government…without the regulatory oversight necessary to prevent excessive risk-taking.
Among the exogenous events, I would include the computer revolution. The ever-increasing power and ever-decreasing cost of computers made financial transactions cheaper and made possible more complex financial instruments and more sophisticated risk-management techniques. Only with hindsight is it possible to sort out the uses of computers that provided genuine gains in efficiency from those that produced self-deception and overconfidence.
Johnson and Kwak reconstruct the dominant point of view in the regulatory community, which amounted to complacency and cheerleading for innovation. p. 103
At an August 2005 symposium…Raghuram Rajan presented a paper asking in prophetic detail whether deregulation and innovation had increased rather than decreased risk…Fed vice chair Donald Kohn responded…”As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market.”
Jumping ahead to their concluding chapter and policy recommendations, p. 219:
A real cap on bank size will not only level the economic playing field and reduce the incentive for banks to take excess risks predicated on the government safety net, but it will also weaken the political power of the big banks…Without a privileged inner core of thirteen (or fewer) bankers, the financial sector will be composed of thousands of small companies and dozens or hundreds of medium-to-large companies…The financial lobby will continue to be strong by virtue of its sheer size…But the distortion of the playing field in favor of a small number of megabanks will come to an end.
Let me finish this review with a few quibbles.
1. I think the authors over-emphasize ideology and under-emphasize exogenous factors in their story of how the 1930’s regulatory structure broke down. Although they mention inflation, they do not spell out exactly how the 1970’s inflation forced changes to the financial system and produced the savings and loan crisis. Nor do they make clear that the growth in securitization in turn emerged largely as a policy-driven response to the savings and loan crisis. It may be too easy for readers to ignore the occasional doubts that Johnson and Kwak express about regulatory technocrats and to dismiss the recommendation to break up big banks as needlessly radical. Instead, a reader with a predisposition to favor progressive government could conclude from the book that the solution is simply to insulate regulators from free-market ideology.
2. In my view, the authors make too big a deal of the issue of over-the-counter derivatives. Suppose that the advocates of regulation had gotten their way in 2000. My conjecture is that we still would have had a housing bubble and a financial crisis. The hypothetical regulated-derivatives world would have been little different from, and not even necessarily better than, the actual world.
3. I was confused on p. 125, where it seemed that Johnson and Kwak viewed J.P. Morgan’s BISTRO as the progenitor of the credit default swap. I thought that BISTRO was the progenitor of the tiered collateralized debt obligation, in which default risk was layered into various tranches so that that top tranches could get AAA ratings. I may be wrong about either the financial history or about my interpretation of what Johnson and Kwak are saying.