Thinking About Financial Reform

By Simon Johnson, co-author of 13 Bankers
There are three contending narratives regarding the financial reform legislation that this week approaches its final hurdles in the US Senate.
The first narrative is “the reforms would make things worse.”  This view, advanced recently by some Republican leadership, seems to have receded in recent weeks – at least with regard to systemic risk – particularly after Senator Ted Kaufman dealt with it rather brutally on the Senate floor.  For the most part, this line has sunk down to the level of sneaky astroturf campaigns.
There is still a rear-guard action by special interests against consumer protection on financial products, but here the administration started out with a sensible vision and – with strong support along the way from the likes of Elizabeth Warren – reasonable safeguards will eventually emerge.  The biggest remaining item is probably the Whitehouse Interstate Lending Amendment, which would definitely help – call your senator, but only if you don’t like being gouged by credit card companies.
The second narrative is “Obama administration as heroes.”  Against the odds, in this view, the administration has prevailed in the teeth of tough opposition.
The problem with this story is that – even in the official version – the only people who have been trying hard to strengthen reform, beyond the initial proposals, over the past year are those relatively outside the main White House-Treasury team: Gary Gensler and Paul Volcker.
Gensler has won some battles – although the final outcomes on derivatives are not yet clear.  And, in any case, the industry won its main battle some months ago when the “end user” exemption prevailed.  The big broker-dealers in over-the-counter (OTC) derivatives mobilized their clients to lobby the Senate Banking Committee – it was all handled in the most professional and (socially) damaging way possible.  This loophole seems relatively small now (10-15 percent of all OTC derivatives), but no doubt it will expand greatly over time.  Watch this space closely for the next crisis.
Volcker’s ideas are still in play – in fact, the big fight this week will likely be on the Merkley-Levin amendment, which would greatly strengthen the idea that the biggest banks should stop already with their “proprietary trading”, which leads them into great and completely botched risks, as well as repeated conflicts of interest with their clients.
The big banks have no good arguments on their side – they are reduced to asserting that being able to take risks in this manner actually makes the system more stable, a point directly contradicted by their experience in the run up to September 2008.  It was the bank’s own holdings of “toxic assets”, you may recall, that were the focus of rescue attempts organized by both Hank Paulson and Tim Geithner.  Holdings at this scale were not acquired in the day-to-day mundane business of bringing buyers and sellers together.  Instead, very smart people at the big banks thought this was a good investment – a point on which they proved devastatingly wrong.
The administration says it favors Merkley-Levin, but let’s see how hard they fight for it.  Personally, I rather expect their support will be lukewarm and this will ultimately not tip the balance.  I’d be happy to be proved wrong.
More broadly, of course, all of these reforms add up to little more than “baby steps”.  The big mistake was made long ago, when the administration decided not to push the megabanks when they were politically weak (the argument of 13 Bankers).
As a result, the financial system will remain largely the same as it was before September 2008 – perhaps the megabanks will be slightly constrained in their activities, most likely not (at least for Goldman, JP Morgan Chase, and Morgan Stanley.)
As we argued in our start-of-the-year piece on Bloomberg, all of this sets us up for another boom-bust cycle, this time centered around emerging markets.  Savings will be recycled out of emerging markets through “too big to fail” banks and similar institutions in the US and some parts of Western Europe – generating debt-based capital flows back into other parts of those same emerging markets.
“China can only go up”, “Russia is back”, and “Brazil and India are now different” are the siren calls.  And of course, to some extent there is truth in this rhetoric – but the expectations are already becoming exuberant.
All great bubbles begin with a truly convincing shift in fundamentals.  And many of them are all kept going by reckless lending on the part of Citigroup and its competitors – remember emerging markets in the 1970s and 1990s, US commercial real estate in the 1980s, and US residential real estate in the last decade.