Obama’s Achielles Heel

Author: Eric Uhlfelder

1 June 2009, Interview With Simon Johnson

While he agrees with much of what the US administration is doing to confront the economic crisis, Simon Johnson, the former chief economist of the International Monetary Fund, fears that present policy is not confronting a key issue: the tremendous influence of the finance industry in US economic affairs. He likens this imbalance to what we see at the core of many emerging markets crises. And Johnson thinks recovery can’t succeed unless the administration breaks the financial oligarchy that is sustaining the status quo and preventing essential reform. And without such reform, he warns things could get much worse. We caught up with Johnson to get his take on the financial crisis and to see what he thinks lies ahead for the US economy.

What surprised you the most about the financial crisis?

When I was chief economist at the IMF in the spring of 2007, the fund expressed some serious concerns about deteriorating economic conditions. But the leaders of the G7 had assured us that everything was under control. These people included under secretaries of Treasury, deputy ministers, and deputy central bank governors. Then as the financial markets began to seize up in early August of the same year, I was shocked by how unprepared the G7 was.

What does this tell you about these leaders?

I think that everyone, including myself, bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed. So I really can’t point too much of a finger at the G7. They certainly weren’t alone in being caught unawares.

Given that acknowledgement, how can investors feel confident with what officials are telling us today?

That’s a great question. We should be very skeptical about what we hear from all officials and experts, and of course that applies to me as well. I think we have learned that we don’t know nearly as much as we thought we did about the functioning of financial markets and how they can get into trouble.

So then, do you feel confident that the policies that have put in place will actually work?

Let’s divide the assessment between broad economic issues and dealing with the banks, which largely got us into this mess. I like what the US administration has done in its mixed bag approach. It makes sense that if you’re not sure what will work, you try a bit of everything: you have some fiscal stimulus, you have some support of housing, and you try to act on the banking front. To my way of thinking, they have been a little overweight weight on the fiscal stimulus. I would have been a bit more evenly balanced.

For certain I think the administration has been far too deferential to the big banks, trying to bend over backwards not to really annoy or harm their interests. This is a fairly substantial disagreement I have with the administration. Overall, however, I think the administration has done a much better job than the last one in putting together a package that has a chance of turning things around.

But there could be an Achilles heel, and it’s likely to be the banking system. That’s where many distressed economies often get into trouble. We’ve seen even when a lot of good policies were in place that if you’re not fixing the banking system up front–that is to say, if you don’t recapitalize it sufficiently, and you don’t replace the people who got you into trouble in the first place–then those deficiencies could work against everything else you’re doing.

Why hasn’t the government been more firm with the banks?

The reasons the government gives is that it’s concerned stricter demands would further damage the banking system, which will cause additional problems for the economy. Behind that kind of logic is the belief that big finance is important and good for the economy, and you need to support financial intermediation with whatever means you got during a crisis like this. But if a troubled third-world nation was making this kind of argument, we would regard it as a mistake, and I think it is a mistake here too.

That said, it is possible that banks could avoid having to write off every bit of toxicity, avoid wiping out equity holders, and having debt holders take a substantial hair cut by earning their way of out the crisis. In this way, they could replenish their capital bases.

Could that actually happen?

Certainly it’s possible. But the question is at what cost? How much growth do you give up and how much additional fiscal stimulus do you have to throw in, and therefore how much additional government debt do you incur to cushion the economy while the banks struggle to recover? With this strategy, we will be adding an extra 10%-20% of debt relative to GDP. This is extra cost that will be incurred by current and future taxpayers so that banking executives can keep their existing bonus structure.

Ultimately, deciding which way to go is a judgment call. But yes, I think there is a difference, and the IMF, often at the urging of the US government, tells countries that run into big banking crises to sort them out up front and to clean up the banks and to recapitalize those that will remain in the private sector.

But IMF typically intervenes in much smaller countries. Should the thinking change when dealing a mega banking system that impacts markets around the globe?

Not to my way of thinking. But obviously Treasury disagrees.

Perhaps the impact of letting Lehman Brothers fail spooked the administration from considering the harsher medicinal approach?

Lehman’s failure scared everybody and everybody should’ve been scared. I don’t think liquidating big firms in the height of a panic is the way to go. But things are much calmer now, and I think you can address the banking system on a different basis. But the government has clearly decided to punt and to pursue forbearance, hoping that if it buys the banks enough time, the economy will eventually get back on its feet. It then hopes the value of underlying assets will revive, which will eventually repair the banks’ broken balance sheets without having to force major systemic banking changes.

Have we seen the worst of the financial crisis?

I think the financial markets have likely seen the worst. The panic phase is over, so I think confidence, calm, and stability are returning to financial markets. But we are now seeing the repercussions of the financial fallout on the real economy. It does look like credit will remain tough to get if you’re a small business. And we know there are sectors that are still slowing down and laying off, including but not limited to everything around automobiles. So I don’t think we’ve seen the worst of the repercussions.

Could lending freeze up again?

I think banks have enough guaranteed support now and enough lines of credit from central banks and so on that I would not think interbank credit would seize up again. But I don’t think normal credit will flow as freely as we were use to and that’s definitely an issue. I think credit will remain tight going forward for the next couple of years.

What are your thoughts about the Stress Tests?

It was clear from the start that the stress scenarios were too mild. One problem is that the government chose levels that were high by historic proportions, but were not high enough relative to the tsunamis we see coming. Current credit card default rate, for example, is 15 percent. The government set 20 percent as a worst-case scenario, a level I think we will breach. And I would say that there’s a good chance we’ll see breaches in the stress rates set for residential and commercial mortgages as well.

Do you worry that the large number of resetting Alt A and Option-ARM mortgages could set off another massive wave of defaults?

Sure. But here’s the difference between what we’ve already seen and the next wave:

subprime was unexpected; but this shock we see coming. But I’m afraid we haven’t adequately prepared for it. The stress tests are not requiring the banks to adequately provision against this likely fallout.

How far off are the findings of the Stress Test?

Perhaps by a factor of two. The results of the stress test were comparable to the IMF’s most likely, baseline scenario. We really need to look at the IMF’s stress-test scenario to see what the losses might be. However, the IMF doesn’t publish these numbers. The government low-balled everything, and then they let the banks negotiate from that basis.

Is the market buying the results?

The government has signaled that it will support the banks for the foreseeable future to an unlimited degree. So the market is reassured by that. However, nobody I met, including people at the Treasury, think the stress tests were completely credible. But that wasn’t the point. The stress tests were a much more a general expression of government support.

Are there limits to how much debt the government can take on to confront the crisis?

There are some limits. But so long as US interest rates stay low, than that limit could be very high. According to the Congressional Budget Office, Debt-to-GDP will get above 60 percent over the next couple of years. [We started the crisis at 40 percent] But we could easily get to 80 percent.

Are there enough buyers of Treasuries to sustain this kind of debt expansion?

Sure, but the question is, at what interest rate? Goldman Sachs is projecting that the yield curve will steepen as a lot more debt is sold. Bank-mediated sales will help them become more profitable. So there is a little bit of a self-fulfilling, self-justifying feature to this scenario. Not a very good one, however, if you’re a taxpayer. But it’s fine if you’re a bank executive.

What is your outlook for growth and unemployment over the next several years?

I expect we’ll see a further contraction in the US, followed by several years of flat, slightly positive growth through 2011. In 4 to 5 years, the US should be growing at a decent pace because of recovery and the low baseline to which GDP will have fallen. Unemployment will peak around 11 percent and will take some time to come down.

The eurozone will be fairly anemic for some time and its recovery will lag behind that of the US. Unemployment will likely rise even higher than the US and will stay higher for a longer period. You’re seeing tremendous hits being taken by some of the formerly fast-growing economies of the eurozone, including Spain and Ireland. The UK’s economy is seriously contracting. Overall, I don’t see any stimulus or strategy that will likely restart growth.

The question about emerging markets is if they can mitigate their own form of reckoning through local fiscal stimulus. Few countries can afford the level of stimulus that we’re seeing in China. This will help the Chinese sustain growth in the 5-8 percent range. But I suspect its economy will eventually slow down too. Ultimately, I would expect most emerging markets to experience rather anemic growth over the next several years as they experience blowback from developed market contraction. For sure they’re not going to provide western economies with much of a boost. But their growth could keep us from staling out.

What do you make of the current market rally?

It’s mostly a reflection of the end of the panic phase of the crisis and calm returning to financial markets. But I don’t think those two features carry you very far because we’ll need to see a turnaround in the real economy before investors believe that the current rally is sustainable. They’ll also need convincing that monetary and fiscal policies that are helping to drive recovery are sustainable as well.

Do you support the policy of Quantitative Easing?

Yes, over the short run. This has involved the Federal Reserve pumping dollars into the economy through the purchase of Treasuries, high-quality mortgage-backed securities, and other privately-issued debt. Over the longer term, however, the issue is how to disengage that credit from the economy, and avoid significant inflation, a process known as quantitative tightening.

Has this been done before?

Not really. In modern times, this is pretty unprecedented.

Are you concerned about deflation or inflation?

I think the deflation scenario is receding as the economy appears to have bottomed. I think we’re going to see a significant amount of inflation because of the difficulties related to quantitative easing.

How should investors respond to inflationary concerns?

Certainly I think commodities could become the next investment bubble as investors search for a real hedge against inflation. They don’t have a lot of alternatives. Gold is the classic hedge against inflation and all kinds of other risks. But investors should remember that it’s also subject to all other dynamics, including gold sales by officials. So I would take a diversified approach to commodity exposure.

Do you fear that the Chinese may slow their purchase of Treasuries?

Some fear this. But what else would the Chinese buy? The euro has it own problems, and the pound and the yen aren’t particularly appealing.

To start containing our soaring debt, should the government raise any tax?

Over the next two to three years I wouldn’t want to see taxes raised while the country is trying to work its way through the recession.

What are your thoughts about Bernanke, Geithner, and Summers?

I think Bernanke has done a very good job given his tools. But I think the real test will be whether he’ll be able to withdraw the credit before it’s too late. I think the jury is still out on Geithner. On one hand, he is too close to big finance and he has been too favorable to the banking industry. But on the other hand, he has shown an ability to come to grips with some complex issues. We need to see how he will handle regulatory reform before I can decide what I think of his performance. That will be his defining issue.

Though Summers was against regulating Credit Default Swaps [along with the likes of Alan Greenspan and Robert Rubin], I think poachers can become games keepers. I have a lot of respect for him, and I’ll judge him on what he does going forward rather than on what he did and didn’t do in the past. The jury is also out about what’s he’s doing now. We keep on pushing him for greater clarity on our website [www.baselinescenario.com]. Sometimes he’s responsive; other times not. Ask me again in two years. We’ll know better by then if he has curbed big finance.

You’re worried about the influence of Wall Street in government. But where else is there the knowledge of how US finance works?

Officials are excessively aligned with the interests of the biggest of the big banks. Understand that I’m not anti-financial services. There’s plenty of expertise in and around the industry that would serve us well. But some of the big players, such as Goldman Sachs, JP Morgan, and Citi Group, are overly represented. The result is you get policies and views that are too much tilted towards these institutions. There’s certainly no shortage of smart, talented, experienced people in the industry beyond the Street. Why weren’t they tapped? You’d have to ask Treasury.

Where do you think the Dollar and the Euro are heading?

Starting with the caveat that currency projection is always difficult, I think the dollar will remain stable being that it will retain its world reserve currency status. I don’t see a plausible short-term scenario that would see the dollar giving up much of its value. But that’s a mixed blessing for the US economy because it can’t likely benefit from currency weakening to boost exports and increased foreign direct investment.

I think the euro, on the other hand, is going to struggle a bit because the ECB will be less inclined to pursue quantitative easing. Inflation fears and belief in prevailing social safety nets will likely keep European monetary policy tighter than the states. This will slow the eurozone’s recovery as the euro remains stronger than it should otherwise be.

This is not the policy I would pursue. And I think it shows the deep divisions within monetary union.

Was the news of first quarter bank profits as good as it sounded?

It was certainly a little bit dressed up though improvements gained from changes in mark to market accounting. But there was a positive angle here, notably trading gains. And I think it suggested a positive overall impression about the direction that the industry is heading. And this is giving the government some confidence that it can continue believing in forbearance and earn-out strategy.

How do corporate earnings in general look?

Terrible going across most sectors, except for low-end retailers. And this is likely to persist for another two to three years. Profits will be engineered through layoffs and restructuring. It’s hard to see organic earnings growth returning before the economy does.

That wouldn’t seem to bode well for stocks?

Though we’re past the panic phase, I don’t think we’re going to see the Dow going back to 12,000 or 14,000 any time soon. In fact some people think the US market looks relatively expensive given the current earnings environment. It’s possible that we could revisit the previous lows.

But if panic selling won’t be driving us back down to previous lows, you seem to be suggesting that fundamentals will be driving the next selloff?


Does the change in ‘Mark to Market’ accounting practice concern you?

You bet. They give banks more discretion in the way they value assets, making it a lot easier for them not to mark down assets when their real market value has fallen. I think that’s unfortunate considering the government has instituted various schemes to buy off these various bad assets, considered essential for repairing banks’ balance sheets. This rule change may in fact make banks less likely to sell troubled assets if they can mark them differently on their books. This may result in problems continuing to hang over banks, and we know from past banking crises in other places that that’s not a good thing. And when you’re in the middle of a crisis, it’s especially not good to make things less transparent. Just because some big powerful people are upset with the rules, it’s not a reason to go monkeying with them.

Will the new manner in which banks value assets be clear?

I think the matter is very murky and getting murkier, and that’s not helpful. When other countries get into trouble and respond by making national accounts, bank accounts, or corporate accounts less transparent, the US is usually in the forefront of criticizing such behavior and tells the IMF to make them stop such practices.

What do you fear most going forward?

I’m concerned that we will not have learned our lesson, and will not consider this a wake up call that foreshadows the possibility of even worse events. The banks could conceivably get bigger and possibly cause even greater damage. I fear a return to pretty much the status quo. That’s what the banks want, and politically, they are powerful enough to get it.

But haven’t they been given any incentive to improve and avoid a repeat of this mess?

Not under the existing regulatory structure and corporate governance. Extant are the same rules that allowed the banks to take on massive amounts of risk. Consider what Alan Greenspan said, how deeply shocked he was to learn how irresponsible banks have been, how they ignored all warning signs. So what exactly have the banks learned? That they can behave in this manner and get away with it, leaving taxpayers owning the downside.

So what then must we do?

Think of finance as nuclear power. You aren’t going to uninvent nuclear power. It’s very useful. But at the same time it’s very dangerous, and it needs to be handled with great care. You need to have multiple safeguards, you need to have a failsafe system with independent and redundant oversight to prevent catastrophic meltdowns. Moreover, I think we’re going to need consumer protection and much tougher conventional bank regulation. We also need to find ways to apply anti-trust regulations. But first and foremost, the government must concede that anything that’s too big to fail is too big to exist.


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