Creating the Next Crisis

And it worked – in the sense that we are now experiencing an economic recovery, albeit one with a disappointingly slow employment rebound in the US and some European countries. So what is the problem with the policies of 2007-2009, and why can’t we just plan on doing something similar in the future if we ever face a crisis of this nature again?

The problem is incentives – what bailouts imply for attitudes and behavior within the financial sector. The protection that was extended to banks and other financial institutions since summer 2007, and more comprehensively since the failure of Lehman Brothers and AIG in September 2008, sends a simple signal. If you are big relative to the system, you are more likely to get generous government support when there is system-wide vulnerability.

How big is big enough remains an open and interesting question. Major hedge funds are presumably looking for ways to become bigger and take on systemic importance. Ideally – from their point of view – they will bulk up without attracting regulatory scrutiny, i.e., no ex ante limits on their risk-taking activities will be imposed. If all goes well, these hedge funds – and of course the banks that are already undoubtedly Too Big to Fail (TBTF) – get a great deal of upside.

Of course, if anything goes wrong, everyone who is TBTF – and who has lent to TBTF firms – expects to receive government protection. This expectation lowers the cost of credit for megabanks today (relative to their competitors, which are small enough that they are more likely to be allowed to fail). As a result, all financial institutions gain a powerful incentive to bulk up (and borrow more) in hope of also becoming bigger and therefore safer (from creditors’ point of view, not from a social perspective.)

Top US policymakers acknowledge that this structure of incentives is a problem – interestingly, many of their European counterparts are not yet willing even to discuss these issues openly. But the rhetoric from the White House and the Treasury Department is we have ended TBTF with financial reform legislation currently before Congress and likely to be signed by Obama within a month.

Unfortunately, this is simply not the case. On the critical dimension of excessive bank size and what it implies for systemic risk, there was a concerted effort by Senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks – very much in accordance with the spirit of the original Volcker Rule proposed in January 2010 by Obama himself.

In an almost unbelievable volte face, for reasons that remain somewhat mysterious, Obama’s administration itself shot down this approach. If enacted, Brown-Kaufman would have broken up the six biggest banks in America, a senior Treasury official said. If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.

Whether the world economy grows now at 4% or 5% matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout – and is not now facing any kind of meaningful re-regulation. We are setting ourselves up, without question, for another boom based on excessive and reckless risk-taking at the heart of the world’s financial system. This can end only one way: badly.

Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, , a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.

Copyright: Project Syndicate, 2010.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:

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