2010 March 13 Saturday
Headed For Bigger Financial Crisis?

Simon Johnson thinks regulatory reform of credit markets has so far been insufficient to prevent a replay of our most recent financial crisis.

All crises end – this is actually Larry Summers’s famous line. We avoided a Great Depression primarily because, compared with 1929-31, we have a government sector that is large relative to the economy – and which does not collapse when credit goes into freefall. What exactly did the Obama administration do in ending the crisis that a Clinton or McCain administration – or even Bush – would not have done? The most plausible answer is: Nothing.

Geithner insists, according to John Cassidy, that the Obama administration has “proposed the biggest regulatory overhaul in seventy-five years.” This is the worst conceit. The sad and unfortunate truth is quite the opposite – because Mr. Geithner and his colleagues refused to seize the moment and didn’t break the economic and political power of anyone who mattered, they have doomed us to re-run the same horrible credit loop as before. Legislation may tweak the details, but the regulation and control of systemic risk remains just as weak as before.

Johnson believes that since the "too big to fail" banks are becoming even bigger we are setting up for a far larger crisis that might exceed the capacity of the US government to handle in a crisis.

If we continue to allow banks to grow, as they have over the last 30 years – and did again through the latest boom-bailout-rescue cycle – we head towards a day when Mr. Geithner or his successor will try to save the financial system and will fail.

You might think that is a good thing and for sure it will bring on a big change in creditor attitudes and presumably much stronger regulation. But, just as in the 1930s, first we will have to dig out from under a lot of economic rubble – and we’ll lose a lot more than 8 million jobs.

In a post entitled "Way Too Big To Save" Johnson argues that in the next financial crisis we might find ourselves faced with bailing out a future Citigroup that has assets equal to 100% of the US GDP.

Let’s take that leap of faith and say we use the favorite scheme of Gerald Corrigan from Goldman Sachs – he is widely promoting conservatorship as a transition to wind-down for large complex financial institutions – and let’s say that it “works”.  Presumably this would mean something like the situation with AIG since September 2008, run somewhat more effectively –perhaps without the obnoxious bonuses.  But would that really lower the fiscal costs of stabilizing the economy in the face of a major financial shock?  And could we afford those fiscal costs?

Maybe.  But the experience in Europe is definitely not encouraging.  The Irish state is in serious trouble because major banks failed and were “saved”; let’s not even talk about Iceland (where banks assets peaked around 11-13 bigger than GDP, i.e., the size of the entire economy).  And Switzerland faces serious risks – with banks that had peak assets over 8 times GDP – that the international community apparently just wants to ignore (perhaps because Switzerland is not in the G20 or the even the European Union).

In the UK, one bank (RBS) had assets that were more than GDP (1.25 times, by some estimates).  Ask yourself this: if Citigroup, which was around $2.5 trillion before the crisis (including the off-balance sheet commitments, let’s call that just under 20 percent of GDP) had actually been $5 trillion, would our problems now be larger or smaller?  What if Citigroup – or whoever becomes our biggest bank – reaches $10 trillion or $15 trillion in today’s dollars and then fails, how would you feel about that?

What would US government policy makers do? The Federal Reserve would be tempted to inflate away the debt. We could experience 20+% inflation for a few years. Debt holders would be forced to take a very big haircut as a way to avoid an explicit national bankruptcy.

When Peak Oil hits what I would like to know: Will the resulting downturn be inflationary or deflationary? With declining tax revenues and mounting sovereign debt I expect governments to heavily pressure their central banks to expand their money supplies so as to allow inflation to cut the cost of paying interest on existing debt. A government wanting could prepare for the Peak Oil financial crisis by issuing debt with longer maturity dates. That way when monetary policy becomes inflationary and the market demands higher interest rates a government can ride along paying low interest rates on debt issued before the crisis.

Share |      By Randall Parker at 2010 March 13 04:29 PM  Economics Sovereign Crises

Mercer said at March 14, 2010 4:53 PM:

Inflation is only good at reducing the value of long term fixed rate bonds. Treasuries have an average maturity of four years and some of the their long term debt is indexed to inflation.

If we have another financial crisis I hope some people in government will read advice like Dean Baker wrote in the column linked below that bailing out big banks does not do much good for the rest of the economy.


no i don't said at March 15, 2010 1:16 PM:

Too many words to explain what is so simple: One owes, one pays. I mean, sooner or later; one way or the other.

no i don't said at March 15, 2010 1:43 PM:

Wow, only 2 comments!!

Randy, you really need to freshen up this blog a bit, don't you think? 'Cause I mean, I just don't think the amount of entries your articles are getting lately, is due to general apathy. I'll give you a hand with my input, but come on man..., we all know economy is going down and it's gonna get worse. It's just natural.

Give us something we can work with. Something a little more interesting, controvertial, spicy, like what the U.S. should do about a nuclear Iran, a defiant North Korea or a left-trended Latin America joining up.

Or at least something that reminds of -"Paranormal Activity"- and spooks us all... Like the threat Mexicans and Hispanics are to the U.S. Or something that arouses narcissism, like how dumb those Beanners are who can't even speak English, or how many more dozens of security checkpoints there should be at airports all over the world.

Something fresh, something mentally stimulating.

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