by Simon Johnson and James Kwak
Pantheon Books, 320 pp., $26.95
As the debate over the proper size and shape of the regulatory response to the financial crisis heated up, one phrase in particular continually resounded: “too big to fail.” Sometimes a variant or complement to that phrase tagged along: “too interconnected to fail.” Sometimes, too, thinking about the staggering costs of bailing out banks that were too big and interconnected to fail, we rejoin with yet another phrase: “too big to rescue.” Looking back, some managers have decided that their institutions were too complex to assess, let alone control (some banks, such as Citigroup, are present in over a hundred countries): in other words, “too big to manage.” Simon Johnson and James Kwak now give us a new dimension and a new phrase to ponder. Their historical message is essentially that banks had become “too political to fail”, and their policy demand is, to paraphrase Edmund Burke’s famous motion against the corrupt regime of George III and Lord North, that the influence of banks has increased, is still increasing, and ought to be diminished.
This diagnosis is shared by a large number of influential insiders and policymakers, as well as by academic commentators hither and yon. The former group includes the highly respected giant of American finance Paul Volcker. His solution, the “Volcker rule” restricting proprietary trading, has played a prominent, if not exclusive, part in the Obama plan for dealing with the financial crisis. In a remarkable reversal of opinion, this group also includes Volcker’s successor as Chairman of the Federal Reserve, Alan Greenspan, who recently concluded that if it’s “too big to fail”, then it’s too big to be allowed to exist in the first place.
But for these and other critics of oversized finance, there is a paradox with which to reckon. Governments have responded to the crisis both by rescuing large institutions and by pushing banks together to ensure their solvency. The perverse result is that the degree of concentration in banking in the United States and also elsewhere has actually increased as a result of the crisis. Thanks to this apparent perversity, if not also others, it is very important to understand properly the origins of the phenomenon. Is the accident-prone size of banks and other financial institutions a result of a “natural” process of some sort, meaning in this context some amalgam of technological and social influence, or does it follow instead from particular interests, say, from lobbying in the context of an increasingly plutocratic political culture? That is the question that Johnson and Kwak, a software entrepreneur and former McKinsey consultant, try to tackle in 13 Bankers.
The authors have the credentials to undertake the task. Johnson, a professor at MIT’s Sloan School of Management, established a substantial reputation in the wake of the 1997–98 Asian financial crisis as a powerful analyst and critic of “crony capitalism.” While most economists looked at macro-economic imbalances, he looked at the structure of enterprises and also at their political links. The problem, as he described it, was that a number of emerging-market economies had been taken over by “oligarchs”: in Indonesia, where President Suharto’s family controlled major credit institutions; in Korea, where the chaebol and their banks were deeply intertwined with the political establishment; and, most conspicuously, in Russia, whose oligarchs thought that they were paying themselves as a reward for securing the re-election of Boris Yeltsin. These breakdowns were accompanied by a great deal of lecturing at the time about how the only solution to the problem was to turn to a system of clear and open transparency as practiced in the open financial markets and democratic politics of the United States. Johnson was an academic at the time, and his research provided a great deal of ammunition for the officials who wagged their fingers at Asian “crony capitalism.” He thought that dismantling the links between corrupt politics and corrupt finance was a necessary part of restoring confidence and prosperity.
In a May 2009 Atlantic essay, Johnson applied the same logic with devastating effect to the United States: What had brought the United States into its deepest economic crisis since the Great Depression was essentially the same sort of political infestation of economic institutions had that brought down Thailand, Indonesia and Korea in 1997 and Russia in 1998. Their book follows from this article, offering an updated and more detailed version of what the authors show to be an old problem.1 And appropriately enough, their preferred approach to it bears some family resemblance to the muckraker attacks on trusts a century ago.
On the face of it, the development of the “too big” and “too interconnected” to fail syndrome in the United States followed from the first creeping, then racing deregulation of the banking and financial services sector, a development that owed much to the doctrine that George Soros, Joseph Stiglitz and many others condemn as “market fundamentalism.” It is difficult to dispute that ideas and beliefs about the economic order mattered. Alan Greenspan really believed in deregulation, for instance that “derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.”2 So did Fed Vice Chairman Don Kohn: “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.”3 Tim Geithner, then at the New York Fed, also appears really to have believed that, as he put it, “Financial institutions are able to measure and manage risk more effectively.”4
As this argument goes, from the 1980s on through to the denouement of disaster a financial revolution based on the efficient markets hypothesis proceeded apace. It is as though the raging bull of the famed Chicago School had managed to escape its confinement and, pumped full of ideological steroids, proceeded to run rampant throughout lower Manhattan. It became orthodox economic theology that home ownership could and should be extended without serious limits, and that the innovations of structured finance (derivatives, off-balance sheet vehicles both on- and offshore, credit default swaps and subprime lending) bore no inordinate risk, for as soon as imbalances accumulated, the markets themselves would effect adjustments.
To a considerable degree, the above forensic analysis of the crisis has become the new consensus, but Johnson and Kwak aren’t buying it. Instead, in an extended argument broken up into seven pithy chapters ranging over the whole course of American history since Thomas Jefferson, they offer an interesting alternative argument: It was not just a particular ideological vision of the market economy that drove the super-sizing of the American financial system. That ideology was bought to the degree it was because a good deal of effort was put into trying to sell it. These ideas were packaged and peddled with a particular purpose in mind, namely the antisocial one of extracting gain at the expense of the rest of the economy. There was nothing natural about this. Neither social trends nor technological developments required any of it. Rather, Johnson and Kwak try to show, we have instead a particularly sharp example of what Mancur Olson long ago dubbed “the logic of collective action”, in his book of the same name.
It is not hard to find some evidence for Johnson and Kwak’s view. For example, the financial sector subvented increasingly expensive political contests, which became so much more expensive in part because they were thus competitively underwritten. From 1990 to 2006 campaign contributions from the financial sector quadrupled, from $61 million to $260 million. Christopher Dodd, the Chairman of the Senate Banking Committee, received $2.9 million in campaign contributions from the securities industry in 2007–08 alone. Wall Street was also able to place its people in key positions in Washington. Johnson and Kwak detail the Goldman Sachs connection to both Democratic and Republican administrations and see the shift to a new money politics as particularly characteristic of the Clinton era; the “economic consensus of the Democratic establishment was based on the policies of Clinton, Rubin, and Summers.” In other words, the 1990s produced American as well as Russian “oligarchs”, and they altered the political and economic system here no less than they distorted it there.
The politicians who benefited from the generosity of the financial services industry pushed people who didn’t believe in regulation into senior regulatory positions. Staffed by underpaid agents at the Securities and Exchange Commission and other regulatory bodies and supervised by people who were contemptuous of the idea that regulation might improve efficiency, the agencies unsurprisingly failed to regulate as they were intended to, and their officials seemed to have taken to watching Internet pornography rather than attempting to work out what the banks were doing. Goldman Sachs executives even secured a small but vital change in a requirement buried deep in the “miscellaneous provisions” of the 1991 Federal Deposit Insurance Corporation Improvement Act. They managed to remove the phrase “out of ordinary commercial transactions” from the section of the Federal Reserve Act that gave the Fed the power to make loans in “unusual and exigent circumstances.” Thus the safety net offered to the banks by the government was foolproof: Whatever risks were taken, the institutionalization of “too big to fail” ensured that any damage done would be the ultimate responsibility of the government and its “clients”, otherwise known as citizens or taxpayers.
As a consequence of all this, finance became uniquely profitable. From the early 1990s on, remuneration in an increasingly unregulated financial sector increased relative to other private-sector incomes. Just as the Russian oligarchs captured the state, Johnson and Kwak argue that Wall Street took control of the Treasury and the Fed.
If this is the correct analysis of the problem, the solution in principle is simple enough. Johnson and Kwak propose that banks should be restricted in size to a certain, admittedly arbitrary proportion of the size of the national economy: They suggest that no bank’s assets should amount to more than 4 percent of GDP, and no investment bank should be bigger than 2 percent of GDP.
With all due respect to this analysis, this seems a rather modest and weak conclusion to a very big argument. Would banks of that size not still want to capture rents? Would they not collude? Could still-defanged regulators stop them if they did?
But that is not the only problem with 13 Bankers. It is not entirely clear, to me anyway, that Johnson and Kwak have the forensics right. It is worth examining a third kind of explanation for the explosive expansion of finance over the past two decades, an explanation that begins not in terms of ideas or corrupt politics, but as the result of the development of a global market: Big global enterprises were a response primarily to a big global market.
What were the advantages of size as the 1980s gave way to the past two decades? The creation of big banks was a product of intense competition in markets that are intrinsically difficult to enter. There is nothing unique about the fact of the concentration of enterprise: It happens, for example, in aircraft production, where the world is dominated by just two producers, in automobiles, where a handful of manufacturers are emerging as global companies, and in several other technologically advanced domains.
But there is something different about banking. What goads it toward concentration is not a need to finance large technology investments; it is that the way information works in banking differs from its role in other industries. Banking is largely reliant on confidence and hence on reputation. Confidence works in a peculiar way when the products of an industry are not physical. One can test an airplane or an automobile, see it, operate it and feel its quality and aesthetics. Banks, on the other hand, do not make things, and so the confidence they must build to achieve global economies of scale is of a different nature. The core of financial activity depends on reputation, networks of information and the ability to make markets as well as simply to trade within them.
Two features are peculiar to this activity. First, modern banks developed vast internal trading platforms that enabled them to keep markets in complex products liquid for their customers. In effect, they offered a substitute for the market rather than merely acting within it. Today, in the aftermath of the crisis, there is a still burgeoning sense of outrage that Goldman Sachs and other institutions effectively bet against their own customers, but back then, taking the opposite side of a bet was what the provision of large and insulated trading facilities was supposed to be doing. The result is that there were simple and indisputable competitive advantages to being big.
Second, customers react in a special way to the “black box” character of banks, in which the outside necessarily sees and knows less than the inside. Banks essentially depend on information (originally about the quality of their lending, more recently about the character of the complex financial products being sold) that is not available to their depositors. Faced by that sort of obscurity, a special power of the bank’s brand and reputation arises. Outsiders look to an institution that they can trust, yet they do so in the knowledge that they will never be fully privy to the bona fides of that trust. When trust breaks down, as it did in the weeks and months following the September 2008 collapse of Lehman Brothers, it is very hard to revive it. As it depended on nothing tangible to begin with, there are few if any symbols of reassurance a bank can offer on its own behalf.
In the old days, when banking was stable and regulated securely in a national setting, three or four leading banks tended to form an oligopoly: Barclays, Lloyds, Midland and National Westminster in the United Kingdom; Commerzbank, Deutsche, and Dresdner in Germany; Credit Suisse, SBC and UBS in Switzerland. There were always suspicions of either a formal or an informal cartel of banks that would agree on conditions and interest rates. Regulators generally turned a blind eye to these suspicions because they could rarely prove them true, and because they usually understood the risks involved in upsetting an arrangement that worked for most practical purposes. Competition never worked perfectly in modern banking, which we can date in Europe and America from around the end of the 18th century. Indeed, historically speaking, it failed on a fairly regular basis when speculations of one sort or another pushed markets into excessively risky behavior. But the failures were generally so far apart in time, and people have such short memories compared to the tug of their greed, that the systems rolled along without fundamental adjustment.
In the 1990s and 2000s, however, the internationalization of the global economy and finance with it produced a new landscape. It was a landscape in which, once again, a handful of banks would divide up not national markets but a single global market. Banks maneuvered to get the best position to take advantage of the new financial globalization. That usually meant locating themselves and their activities, via subsidiaries, in the most lax and least restrictive regulatory regime. The megabanks internalized activities that were once performed by individuals and institutions in large part legally independent of one another, or of public markets.
The most effective way to deal with this development and the several pathogens it carries with it is to transfer trading away from in-house trading floors in which the price determination process is obscure, and onto markets that are really open and public: to central exchanges or clearinghouses. That is the logical answer to one of today’s financial flaws: the bigness or lumpiness of financial institutions.
But the other crucial aspect of today’s financial mess lies in the international interconnectedness and the regulatory complexity it creates: This was highlighted in 2008 by the problem of unwinding Lehman and today by the Greek crisis. The problem is global, not national, and it requires a solution on a global scale. It is therefore odd that the global dimension is largely missing from Johnson and Kwak’s analysis.
Indeed, they give an oddly Americentric view of the world. Yet there are many indications that the super-sizing phenomenon they analyze arose out of the perception of competition between global financial centers. The November 1999 repeal of Glass-Steagall was presented as a necessary national response to the establishment of super-banks in Europe, which in turn came about as a consequence of the 1992 creation of a single European market and the introduction of a single currency, the euro. In 2007, Senator Charles Schumer (D-NY) said, “We are not going to rest until we change the rules, change the laws and make sure that New York remains number one for decades on into the future.” Big banks were part of big American power.
It is worthwhile to examine the policymakers who are broadly supportive of Johnson and Kwak’s approach. They all reside in relatively small countries that have become big financial centers, and where the process of political lobbying by big financial institutions has also undermined the regulatory process. Adair Turner, the chairman of the British Financial Services Authority, Andrew Haldane, the director of the Bank of England responsible for financial stability, and Philip Hildebrand, the new president of the Swiss National Bank are all rightly worried that problems in large banks could be impossibly costly to manage. Reforming finance requires coordinated action in many countries. Dealing with one country alone does not solve the competitive issues raised by a world of financial globalization.
There is thus an oddity about the final sections of the book, in which Johnson and Kwak call for the mobilization of populist outrage against the oligarchs to tame the supranational monsters. Their historical heroes are remarkable. They admire the populism of Andrew Jackson for busting the Second Bank of the United States, of Theodore Roosevelt for taking action against the trusts, and of Franklin Roosevelt for opposing banks and financiers. Note that the worlds of Andrew Jackson, Theodore Roosevelt, and even the first term of Franklin Roosevelt’s presidency were periods of relative American isolationism.
But most importantly, neither Andrew Jackson’s nor Theodore Roosevelt’s solutions were conspicuously successful. The end of America’s early experiment with central banking in the 1830s produced a financial system characterized by small, vulnerable banks and repeated bank failures. A deliberately underdeveloped financial system made for not necessarily slower but radically uneven economic development with periodic, spectacular waves of boom and bust, not least because the United States was enmeshed in global credit cycles but lacked the national institutions to keep up with them.
The populist response to the 1907 financial crisis was outrage that the crisis, which had actually been managed very effectively by J.P. Morgan, had led to a strengthening of Morgan’s wealth and influence. There was in consequence a call for a public- rather than private-sector solution, but that call led to an institutional design that made the American economy more rather than less crisis-prone. Discussions of how to deal with 1907 led eventually to the establishment of the Federal Reserve System in 1913, but that system was ill-equipped to deal with the traumas of the following twenty years, and its inappropriate monetary policy amplified rather than dampened the cycles of boom and bust. The United States experienced an unnecessarily harsh postwar readjustment crisis in 1920–21, then a wave of euphoria, and finally, of course, a Great Depression after 1929. The private system that solved the 1907 crisis would almost certainly have done a better job over the ensuing quarter century than did the infant Fed.
The story of the New Deal is more complex in this light. The most plausible story is that the first New Deal was fundamentally botched. The National Recovery Administration, which as many commentators at the time liked to point out seemed to draw inspiration from the corporatism of fascist Europe, was in the end declared unconstitutional by the Supreme Court. However, it had failed as economic policy before it did so by light of the law. In the so-called Second New Deal, Roosevelt took a different path, in which enforcing competition was at the heart of government policy. That approach worked, and it is an effective competition policy that now needs to be implemented, as well, but at a global level, since that is where the problems really lie.
In the course of his presidency, Roosevelt moved away from populism and isolationist responses to thinking in terms of a world designed and held together by rules. That was the vision which was implemented in the great international conferences in the last stages of World War II. FDR came to recognize that good solutions to national problems needed to be embedded in international ones. We should apply that lesson again now, at least insofar as financial regulation is concerned. Looking for exclusively national solutions can at best flip the arrow indicating whose ox is getting gored. All such solutions will provide answers that are simply too political to work.
1An observation that should not surprise readers of this magazine; see H.W. Brands, “Too Big to Fail: The Prequel”, The American Interest (September/October 2009).
2In July 2003 to the Senate Banking Committee; see 13 Bankers, p. 102.
3In a lecture at Jackson Hole on August 27, 2005; see 13 Bankers, p. 103.
4In a lecture in New York on February 26, 2008; see 13 Bankers, p. 106.