Simon Johnson on the financial crisis and Obama’s advisors

LW: MIT economist Simon Johnson explains that the policies embraced by key members of Obama's economic team are opposite those they supported during the Asian financial crisis of the 1990s. This charge applies in particular to Lawrence Summers, in charge of the White House National Economic Council, Treasury Secretary Timothy F. Geithner, and David A. Lipton, who is now at the National Economic Council and the National Security Council. All three were heavily involved in preparing a US response to the Asian financial crisis.

“In the 1990s, they were opposed to unconditional bailouts — providing money to troubled financial institutions with no strings attached. .... The Treasury philosophy was clear and tough: "a healthy financial system cannot be built on the expectation of bailouts," Mr. Summers said in his American Economic Association speech in 2000. ...

“In the 1990s, the United States — working closely with the I.M.F. — insisted that crisis countries fundamentally restructure their financial systems, which involved forcing out top bank executives. In the United States during 2009, we not only kept our largest and most troubled banks intact (while on life support) but allowed the biggest six financial conglomerates to become larger, both in absolute terms and relative to the economy. ....”

If true, this has a terrible implication. The structure of our financial system has not changed in any way that will reduce reckless risk-taking by banks that are large enough to cause significant damage when they threaten to fail.”
Simon Johnson, "Lessons Learned but Not Applied", Economix (31 December 2009).
http://economix.blogs.nytimes.com/2009/12/31/by-simon-johnson-lessons-lea/


DOW: Simon Johnson is currently the Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 he was Chief Economist of the International Monetary Fund. Recently Prospect Magazine named Simon Johnson as the "clear winner" out of 25 economists who have made notable contributions to "public conversation" during the current financial crisis. Also on the list were Martin Wolf of the Financial Times, Paul Krugman of the New York Times, and Columbia University economist Joseph Stiglitz.

The issue Professor Johnson has focused on in this post is the one of “Moral Hazard”. Moral hazard is the tendency of a person or institution that is imperfectly monitored to engage in dishonest or risky behavior. (“Moral hazard” is another one of those lousy economic terms that makes no sense but is used by everyone anyway.) In the case of financial institutions, moral hazard is the tendency for financial bailouts by governments and central banks to encourage risky lending in the future, if the bankers come to believe they will be bailed out and not suffer personal loss if things go wrong.

Moral hazard has been a concern expressed about the Administration policy since it first took office. The objection is both that Wall Street has not simply been “saved” from its own stupidities but that the very people that made disastrous decisions have benefited from the very mistakes they made. This, it is argued, will only encourage them to be even more reckless in the future and, anyway, they should be fired and not benefit from their mistakes.

Nor has the issue of moral hazard been limited to the banks, as the Administration also bailed out auto companies, investors in housing, states and localities, and pension funds, among others. The fear on the part of the critics is both the unfairness of shifting the costs of all these bailouts to the taxpayer and the precedent it sets for the future.

As Simon Johnson notes, the problem of moral hazard is well understood by President Obama’s economic advisors. When addressing the question of bailouts at the international level in 2000 Larry Summers had this to say about the problem of moral hazard in his speech to the AEA:

“… as in the case of an efficient and incentive-compatible deposit-insurance and safety-net scheme, possible moral-hazard distortions induced by automatic guarantees need to be avoided to ensure that the scheme does not lead to systemic losses and distortions. Thus, it is certain that a healthy financial system cannot be built on the expectation of bailouts.”

American Economic Review, Vol. 90, No. 2 (May 2000).

But bailouts are exactly what the Obama Administration’s policy has been. Wall Street is back in business earning huge profits and its executives are back in their offices receiving the huge bonuses. Car companies are living off the public dole and their executives are still receiving high salaries. Fannie and Freddie are still in business, still paying exorbitant salaries to their management, and still near financial collapse. Yet the rest of the economy remains in the doldrums and employment is still sinking.

It’s hard to understand why bailouts were bad policy during the Asian financial crisis in the 1990s and yet bailouts are wise economic policy for the U.S today.

Thanks to Larry Willmore for the Tdj.Presumably this time, the Summers-Geithner-Lipton group will argue that the only way to restore confidence was through the kind of unconditional and implicit bailout guarantees they opposed in the 1990s.