The Coming Meta-Boom and Meta-Bust — One Economist’s View

Simon Johnson, a former chief economist for the International Monetary Fund and author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, says the recently passed Dodd-Frank Financial Reform Act does little to prevent the biggest financial risk of our time — banks that are becoming “too big to save,” either because potential losses could overwhelm government resources, or the public will refuse to sanction another large bailout. Either way, the world economy could crash. But preceding any crash, watch for a worldwide “meta-boom.” Following a recent talk Johnson gave at Wharton, he discussed this and several other issues with Knowledge@Wharton, including how shrinking big banks could ward off financial meltdowns, Ireland’s solvency-threatening debt burden and the implications of Basel III.

An edited transcript of the conversation follows.

Part I
Part II

Knowledge@Wharton: We’re speaking today with Simon Johnson who is a professor at MIT, former chief economist at the International Monetary Fund and author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Welcome.

Simon Johnson: Thanks for having me.

Knowledge@Wharton: In your book, which was written before the recent financial legislation passed, you have a sentence in there that’s predictive. And it says, “It’s likely our government will use this legislative cycle to declare victory over the financial crisis, without addressing its most fundamental causes.” Is that what’s happened in your view?

Johnson: I’m afraid so, yes. The book was finished in January of this year. The legislation was debated most intensely in the Senate in March and April and it passed in the summer. There were some steps in the right direction. This is the Dodd-Frank Financial Reform Act, and [it contains] some steps that I definitely support. But it’s not enough and it doesn’t really address the fundamental causes. I think the financial system, if anything, is becoming more dangerous than it was, even before 2008.

Knowledge@Wharton: Could you tell us what were the positive points in the bill, just a brief summary of your views, and what the big gaps were?

Johnson: Well, the big positive was, obviously, consumer protection and the fact that the President has now put Elizabeth Warren in charge of figuring out how to … build [the new Consumer Finance Protection Agency], as mandated by the statute. That’s terrific. That’s exactly what we needed. But in terms of system risk, in terms of making the biggest banks less risky, in terms of reducing the kinds of interconnections that almost brought down the world’s financial system at the end of 2008 and early 2009, the legislation makes very little progress, if any, in the right direction there.

Knowledge@Wharton: Of course proponents would say that it did make progress and that it has ended the worries about “”too big to fail”.” You obviously disagree. Can you tell us why?

Johnson: The heart of the argument on behalf of the Dodd-Frank legislation, with regard to “”too big to fail””, is that there is now a resolution authority and a resolution mechanism. So the FDIC, on behalf of the government, can take over, shut down, manage the failure of any kind of financial institution. Previously they could do it for depositary institutions, banks with insured, FDIC insured deposits. Now in principle they can do it for everyone. But they can’t, because our largest banks are global banks. And there is no cross border bank resolution failure mechanism. Nor is the G-20 taking up the issue of how to construct one. Nor do any of our major trading partners want to have such a mechanism.

So if Citigroup, hypothetically, were to fail, and Citigroup operates in more than 100 countries, how would you manage that? What would the FDIC do? What’s the mechanism for the failure, for losses to be faced by creditors? And the answer is, if you take this up directly, face to face, off the record with senior administration officials, they’ll concede the point. They’ll say, “Well, actually we would support the institution. We’d have to. We’d have to do a conservatorship.” Conservatorship is a bail out. Conservatorship is protecting the creditors. That’s not a resolution mechanism. And the creditors know this. So the big banks, the global banks, the ones at the heart of the previous crisis are invulnerable in the sense that their creditors cannot face losses.

Knowledge@Wharton: So without a global mechanism, really, the United States, however well intentioned, would be unable to protect against banks that are “”too big to fail”” because they could crush the system ultimately? And so does that mean that bankers today are back, again, to being confident that they can take on what I think you call in your book “excessive risk”? And that the public will take care of any downside and the bankers will be able to skim off the upside, which is what people perceive happened last time?

Johnson: Yes, that’s exactly where they are. Of course there’s the [economic] cycle, and right after a major financial crisis, you’re going to be somewhat careful. That’s understandable. That’s why you don’t see back-to-back global financial crises, not year in year out. But over time, as we go through the cycle, we’re going to have the same sort of risk taking. Jamie Diamon [CEO and chairman of JPMorgan Chase] says you have financial crises every three to seven years. Hank Paulson [former Treasury Secretary] says its four to eight years. [Treasury Secretary] Larry Summers says four to nine years. Doesn’t matter, these big guys agree and they’re right, that you do it again because the system of incentives and the structure of these organizations are essentially unchanged.

Knowledge@Wharton: So then the question starts to be, what else might be done about that? And you quote Alan Greenspan, of all people, in your book saying that “if they’re “too big to fail”, then they’re too big.” He goes on to say in his prescription — and this was just about a year ago, so not all that long ago — “Break them up. In 1911, we broke up Standard oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need.” I know that this is what you advocate in your book to some degree. Break them up in the sense of reduce their size. So could you talk about how that would work? I know you talk about size limits and you have some ideas and mechanisms on what that would look like.

Johnson: Absolutely. This is the heart of the matter. In addition to Alan Greenspan, I’m now citing Gene Farma, the father of modern finance, the person really behind the idea of efficient markets in finance, who said on CNBC recently after we finished the book, “‘”too big to fail”‘ is an abomination. It’s not a market, it’s a government subsidy scheme and it should be ended.” And the best way to end it is to update and apply the Riegle-Neal Act of 1994. Riegle-Neal sets a size cap on our largest banks as a share of retail deposits. No bank can have more than 10% of total retail deposits. The idea that was proposed as an amendment to Dodd-Frank by Senators Sherrod Brown and Ted Kaufman was that there be a hard size cap in terms of the size of bank, relative to the U.S. economy.

Knowledge@Wharton: Relative to GDP?

Johnson: Exactly. Relative to the GDP so that nobody, no individual bank can become bigger [than] your economy. Now we can discuss where that limit should be drawn. I would definitely be in favor of a much lower limit. We can put a dollar number on it if you like. But that basic idea of a hard size cap beyond which you cannot go, I think, is what you need in the American situation.

Knowledge@Wharton: I think in your book when you were talking about what that level should be, you said something that would be akin to where banks were in size in the mid 1990s or so. So we’re not talking about Draconian reductions.

Johnson: Absolutely. So Goldman Sachs in the late 1990s was about a $200 billion bank. Let’s call it $250 billion in today’s money. Before the crisis in 2008, their balance sheet peaked at $1.1 trillion. Now what did the U.S. economy as a whole, what did the financial system gain from that big increase in size with Goldman Sachs? Nothing. No one can point to any economies of scale or scope or other benefits from increasing size above about $50 billion in total assets.

So there were lots of benefits for sure, private benefits for Goldman Sachs. The CEO gets more compensation, definitely. The CEO, by the way, in this period of rapid growth was Hank Paulson, who later became Secretary of the Treasury. But if you go back, if you ask or force Goldman Sachs and banks like that to go back down to the days where they were $200 billion or maybe we even end up with $100 billion as the hard cap, what’s the damage? What do you lose from that in terms of either the functioning of the American economy or the functioning of the global financial system? And the answer, from all the experts I’ve talked to, both academic and practical people really in the business, the answer is you wouldn’t lose anything. You don’t remove system risk completely of course. There is no magic bullet. These measures we’re proposing are surely not sufficient to reduce financial system risk. We’re just arguing that they’re necessary and also that they haven’t been taken.

Knowledge@Wharton: The other interesting stat in the book, I think I’ve seen this elsewhere also, is the percentage of corporate profits that the financial industry represents. I might be off a little, but I think this is roughly right: that up through the beginning or middle of the 1980s, or maybe even a little bit later, the most the financial system ever took up in total corporate profits in the U.S. was about 15%. But just prior to the crash, it was up to 41%. In other words, the financial services industry was earning 41% of all profits in the U.S. That’s something that we never even got close to in the past. It suggests that maybe something was out of whack. Why didn’t anybody see that? Well, I know some people did. Where are we now and how long do you think it might take before we get back up to that, according to your view of what’s likely to happen?

Johnson: Well, we’re heading back into similar territory. The financial sector profits are strong. And I think they’re going to really do well, partly because there are fewer of them. There’s less competition, there’s more market power in this area. But you’re absolutely right. It’s a wakeup call, because those are not real profits. Those are not risk adjusted profits. Those are not profits, if you go back and state them against the losses that were incurred, because a lot of those losses were transferred to the taxpayer. Larry Summers says that financial sector profits at 40% of total corporate profits is a warning sign and we should have taken it as such. He’s absolutely right. When you show those numbers to the CEOs of non-financial companies, they’re staggered actually, and quite shocked. And so they should be, but they won’t do anything about it. They won’t even participate in criticism of the financial sector. They’ve actually closed ranks, protecting the biggest banks. And that’s very dangerous for them, individually, for their companies and for all the people who work for them, because this is the big risk facing the United States going forward.

Knowledge@Wharton: The other thing that’s interesting — and you talk about a number of different problems with “too big to fail”, such as taxpayers ending up on the hook for all the money — is this idea that because of the backup, the backstop, the implicit guarantee, the moral hazard is basically there, but only for the very largest banks. The next tier down, say large regionals and so forth, are actually put at an unfair disadvantage competitively because they don’t have that subsidy, and therefore they can’t operate in the same way. So it’s not a level playing field. And yet we don’t see too much opposition from them either. You just talked about the corporate sector in general, what’s going on here?

Johnson: That’s a very interesting question, and you should pose it to the bankers themselves. I don’t think I can speak on their behalf. But I certainly agree and underline, there is a big divergence in interests between the massive, the mega banks, the mega global banks that have this implicit government guarantee now and therefore a lower cost of funding, and the banks they compete against in many markets, including the midsized banks and the community banks. It’s not fair. It’s a government subsidy scheme that’s not fair, not transparent and very dangerous.

But the U.S. corporate leadership, unfortunately, feels they should stick together in situations like this. The Chamber of Commerce has certainly spoken out consistently on behalf of the big banks. And claiming to speak on behalf of small business, it has opposed almost all of the sensible provisions of the Dodd-Frank Financial Reform Act. I find this extraordinary and disconcerting. And I spend a lot of time — I’m a professor of entrepreneurship at MIT, among other things — talking to a lot of business people. I work with entrepreneurs in the U.S. and around the world, and I spend a lot of time with them on these issues. I think over time their view will change, but it is unfortunate. It definitely affected the political process in this go around that the business sector, the non-financial business sector didn’t get it. They don’t understand how much they and their families and their people have been damaged by the irresponsible, reckless, unnecessary behavior of the big banks.

Knowledge@Wharton: Given that you don’t think that the latest round of financial reform has done the trick, let me just turn to something else that you say in your book. “We face the prospect of a 1920s style rollercoaster,” meaning the economic cycle will be more volatile. And then you say, “This is a recipe not for stagnation, but for a meta-boom in which we will receive warnings, including painful recessions, but consistently ignore them.” And one last thing: “The 1920s opened with an 18-month recession, an eerie parallel to the 2007-2009 experience. It ended with the great crash of 1929.” So not that we want to be talking about Depression necessarily, but I think you want to talk about volatility and certainly recession such as we have now. Or maybe you do want to talk about the Depression.

Johnson: I want to emphasize that “”too big to fail”” is not the worst of our problems. I actually had this conversation recently with a leading banker, a gentleman with a great deal of international experience. He said, “Well, look, “too big to fail” is part of the scenery now. You’ve just got to deal with it.” Now I agree on a tactical level that this is actually correct. I don’t think that there is anything on the table or waiting in the wings that will make any difference to the rising power and the dangers posed by these big banks. But “too big to fail” is not the worst of our potential problems. That would be Too Big to Save. Think about Ireland.

Knowledge@Wharton: Too Big To Bail.

Johnson: Absolutely. Ireland allowed its three largest banks to build up total assets two times the size of the Irish economy. And then they failed. The Irish government issued a guarantee that at least, as we speak today, covers all the liabilities of those banks. They turned a financial banking sector into a fiscal issue, in my view, and this is something we write about on our website and we go through the analysis. I certainly disagree quite strongly with the views coming out of the official sector, but I would point out the market is moving in my direction on this issue. My point is that Ireland can’t afford the bailouts they’ve taken on. It’s not fiscally sustainable.

Knowledge@Wharton: So it’s kicking the can down the road?

Johnson: Well, it’s trying to kick the can down the road … but it’s not moving. The can’s too big, right? You’re going to break your foot. You’re looking at a fiscal disaster. You’re looking at a sovereign debt issue. And I think we must take this seriously for the United States.

Knowledge@Wharton: When will that actually hit the wall though? Because I say “kick the can down the road” in the sense that there’s no panic, there’s no strong reaction. There was a strong reaction and then certain steps were taken. Maybe we can talk about that, because I know also in that blog piece, you talked about one possible way out for Europe is to issue some form of Brady bonds, which were used to help bail out Latin America, which I think essentially just spread the debt out over a long period. Is that right? Is that the main mechanism that allowed them to work? And you’re recommending that those be used in Europe as well?

Johnson: What happened in Latin America at the end of the very difficult and essentially lost decade of the 1980s was that they restructured their debt. They were allowed to extend their payments, reducing the debt burden, reducing the cash. There was a, let’s say, regulatory compromise reached, including the Brady bonds, that allowed the banks not to mark down their debts so much. So this is how they squared the circle of not wanting to recognize the losses among the lenders, and letting the borrowers get somewhat off the hook.

Knowledge@Wharton: So it was a forgiveness of debt, a little bit, without it being recognized. So it was a sort of fudging?

Johnson: It’s how you forgive the debt in a situation where you don’t want it to look like you’re forgiving the debt. So something like that for Ireland and maybe for other Euro zone countries, I think, should definitely be considered seriously. It is unfortunate that the official sector never wants to consider such options until it’s too late, until they have to scramble, until they have to do things in a manic rush over a weekend. I think now is the time to prepare for that kind of sovereign debt restructuring.

And as we look forward, I would emphasize that while the moral hazard in and around the big banks is absolutely huge and will be a major problem that we face, resolving that — looking at the implications, the moral hazard around lending to governments, governments that are regarded as safe — will also be an issue.

Knowledge@Wharton: Can you define moral hazard for those people who aren’t clear what it means?

Johnson: Moral hazard is very simply that when I give you insurance, you’re going to be a little bit less careful. It’s interesting, if you go back to the foundation of the Federal Reserve, 1913, quite late for the formation of a modern central bank compared to other countries comparable to the United States, there was a big debate about this issue, because the bankers said, “We want protection. The financial markets have gotten too big, too complex. We can’t support ourselves.” This is what they learned in the crisis of 1907. “We need the government to be involved.” In fact, the government had put in a big amount of cash in 1907 to save some of the private banks.

The debate was, okay, you, the bankers want support. That’s fine. Nobody wants a global or even national financial collapse. But there has to be a quid pro quo. We need some oversight, we need some regulation, or what we now call regulation supervision. That’s the essence of the moral hazard problem. But unfortunately, it hasn’t worked. It didn’t work, by the way, in the 1920s either. That’s why you got a runaway boom; the banks went crazy in terms of taking risk and keeping risk on their own balance sheet. That’s where they got the reforms of the 1930s. Those worked for about 50 years. And then they were systematically, carefully, with a great deal of forethought, dismantled. That’s why we got the crisis of 2008. We did not, though, go out and rebuild the modern equivalent of those constraints that were put up in the 1930s. The Dodd-Frank bill doesn’t do that, and therefore we still have the same problem that we had prior to 2008 and in the 1920s.

Knowledge@Wharton: So that’s the meta-boom cycle that you’re talking about, as a parallel?

Johnson: That’s my baseline scenario. We call our website [The] Baseline Scenario, meaning we have a baseline view. We move it from time to time, but as we speak today, that is my baseline view.

Knowledge@Wharton: And since we touched on Europe, could you give your view of the Basel III accords, which is the latest European financial legislation or reforms, and maybe draw some parallels between those and what was done in the U.S.?

Johnson: The Basel III is a global agreement….There are 27 countries on the Basel committee and they agree on a lot of things around bank regulation, with first and foremost the issue being bank capital. The problem of Basel III is that while the U.S. does want somewhat higher required capital in banks, the Europeans don’t, and actually the Japanese don’t. As a result, we end up with a compromise which is what people often call the least common denominator, and which in common English you could say, not enough. So the capital required at the end of the day when you make all the adjustments by Basel III will be about 10% tier one capital. That’s roughly what the U.S. banks have had for the past two decades. So there’s no change in required capital relative to what U.S. bank practices have been.

Knowledge@Wharton: But it will help Europe in some way, presumably.

Johnson: If they follow the rules. Unfortunately they have a track record of providing many exemptions and exceptions to their most privileged banks.

Knowledge@Wharton: Okay. I have a question here that comes from Yves Smith who runs the popular blog called Naked Capitalism. I’m just going to read it. “In your Atlantic article, the ‘Quiet Coup,’ you stated that the hold of the financial services industry on government, which you compared to third world oligarchs, would not be broken. You need to see some break ranks and back reforms as happened in the Great Depression. Clearly that has not occurred,” based on what you’ve said today. “Are you troubled to see discussions in the media ignore this issue, and worse, act as propagandists for the industry by suggesting that the reforms were tough and will inconvenience big banks?”

Johnson: Yes, I think Yves Smith, once again, has hit the nail on the head. It’s about ideology and it’s about what we call in the book “cultural capital.” The financial sector persuaded people in the run-up to 2008 that they were smarter than their predecessors and pretty much anyone else in the economy — that they knew how to organize and manage risk, and they should be allowed to do all kinds of things that a previous generation of regulators would not have permitted. Well, that ideology was obviously shaken by the events of 2008 and 2009. But now we see it coming through again, in an apparently persuasive form, backed of course by a lot of lobbying dollars and a lot of very articulate people in Washington who work on behalf of this sector.

But in essence, I think Eve is right. The essence is, if the media doesn’t get it, if the smartest journalists whom you respect and read every day who write on the front page of major newspapers and on leading analytical serious websites run by those papers, if they don’t get it, if they don’t understand what the financial sector is doing, why and how, then that definitely contributes to the problem.

Knowledge@Wharton: So a related question: I think that there are probably a handful of economists who foresaw the bubble and predicted it one way or another, who forecast that there would be a crash as a result. Those folks were pretty much ignored prior to the financial crisis. Once the financial crisis hit, they then predicted a lot of the things that were going to happen. And you know, first and foremost that it would be a very long recession, that it would be longer than your garden variety because it was a debt deflation-related recession, which is very different, and caused by a financial crash. Research shows that those kind tend to last longer.

They also predicted that unemployment would be high, but ongoing [and] very difficult to get down. So that group has been proven pretty much right. But they still don’t get that much respect in the media and they don’t get that much attention. Meanwhile, the analysts and economists who were mostly wrong on both counts seem to be the ones who do get all the attention. What’s going on there? Why is that and is there anything that could change that?

Johnson: Well, that’s a fascinating question. I think you’ve correctly identified the phenomenon. But you really have to ask the media people what’s going on. I don’t know. It is a puzzle and there are lots of questions that this raises about the nature of information in our society, how experts are created, perceived, perhaps undermined by events. It’s very interesting that even in terms of consequences, in terms of re-evaluating anyone or anything, The New York Times reports that almost all of the board members of the financial companies at the heart of the crisis — where there was clearly mismanagement, clearly a failure of oversight — almost all the people who had board positions still have board positions, still continue in the same sort of places of prestige and power and influence in our society. So perhaps we’ve reached a point somehow in our consciousness or in our mechanisms of evaluation at a social level, where we ignore consequences and we don’t update.

Knowledge@Wharton: That’s an interesting take. You have a lot of historical information in your book, including when you talked about Teddy Roosevelt and how he changed the consciousness in his day. Of course he was well known for breaking up the trusts, breaking up monopolies or oligarchies.

It seems that you are suggesting it’s going to take something like that [today]. The biggest thing that has to happen in your view is a change in public perception. So I’m wondering what comes first, the chicken or the egg. Is it a change in public perception that allows a leader, like a Roosevelt, to come up and do it? Or is it a leader who pulls together the discontent, rallies the troops and makes change for these kinds of difficult issues?

Johnson: That’s a great question, and at least the Teddy Roosevelt parallel suggests, and actually the FDR parallel as well, suggests it’s a combination of events, an articulate segment of the population that is somewhat ahead of the curve, and a leader who seizes the moment and who goes somewhat counter to the current. So, but counter to what you [might have] expected, Teddy Roosevelt was a Republican. Teddy Roosevelt was coming from the party that controlled the Senate. The Senate was known as the millionaires’ club. He was a surprise pick as vice president. He became president only through a bizarre tragedy, the assassination of McKinley. And he picked up ideas that really came from another part of the spectrum. But at the same time, he was tapping into a strong vein of small business sentiment, of independent farmer sentiment that was against bigness and was against, was worried about, concentration of power. So I think you need that combination. You need somebody who’s willing to take the lead on this. I think that’s one of the key pieces that currently missing.

Knowledge@Wharton: And talking about concentration, after this crash, it turns out that — I don’t know if that was 13 banks that you were referring to in 13 Bankers — some of the bigger banks, in an effort to salvage the system, took over competitors. And so now there are really six large banks. Could you talk about them, just how much they control and some of the points you make about them in your book?

Johnson: Sure, well the six banks are, I think, the heart of the problem. Those six banks control, have assets — the size of the banks and balance sheet — of roughly 63%, maybe 65% of GDP right now. Before the crisis, they were 57% or 58% of GDP. And if you go back to the early to mid 1990s, that same group of banks and the other banks that they gobbled up along the way, that same group was 16% of GDP. So they have become much larger relative to the economy. There’s a very important point, that the U.S. is not a country based on big banks. We don’t have a big banking tradition relative to other countries. We don’t have a tradition of bank concentration or of concentration relative to the size of the economy.

There are no benefits that anyone can point to from a broader economic point of view of this increase in bank size. So at the very least, we should roll the banks back to where they were before this merger movement, before many of the barriers on their activities were taken off. And we should also consider very seriously putting other controls and restrictions on the ability of those banks that are essential to our credit system, essential to our payment system, to take huge amounts of risk should be severely curtailed.

Knowledge@Wharton: Well, people who would disagree with that point of view might say something like, “Look, the United States is operating globally. It’s a big economy. Other countries have big banks; we need big banks too.” How do you answer this person?

Johnson: I go talk to the CFOs and CEOs of major corporations, and these people are very accessible and they’re very interested in this question. In their views, the ones I talk to, the ones who go on the record, clearly say that we don’t need banks of this size. The idea that JP Morgan Chase has [to be] a $2 trillion bank in order to provide the kind of financial services, in order for us to get the kind of financial services we need to operate a non-financial company globally, for them that’s a non sequitur. For them that is a story made up by JP Morgan Chase and by other leading bankers. They don’t see it that way, and I say the experts agree with them.

Knowledge@Wharton: Probably they can tap the markets on their own. Is that one reason?

Johnson: Yes, absolutely. What they need are people who are good in local markets. They need the ability, they need deep liquid markets for securities that they care about, and that would include derivatives, for example, so they can hedge some of their risk. That is, I think, understandable and acceptable. But in terms of having to deal with one big bank, they don’t want to do it because that would make them overly dependent on one supplier and they would always like to diversify their suppliers. That’s practical business experience.

Knowledge@Wharton: Another interesting idea that runs through the book is this idea of regulatory capture. Can you explain that and whether you think any progress has been made on that with the latest financial legislation?

Johnson: Well, no progress has been made, sadly. A regulatory capture is an idea that doesn’t come from the left. Some people think this is a left wing book. I don’t think it is at all, in part because regulatory capture is an idea that was really invented and honed by George Stigler from the University of Chicago, who was definitely not a left wing person. He was a right wing person. He pointed out that when you regulate an industry of any kind, over time the industry figures out how to capture the regulators, the minds of the regulators, and persuades them to do things that are in the interests of the incumbents. Really what you get in the classic Stigler view is a collusion between the regulator and the regulated that is against the social interests and against the interests of people who would like to enter that business, so entry barriers would be constructed.

Now what we’ve seen in the past 30 years is George Stigler-type regulatory capture on steroids for the financial sector, where the problem is not just collusion between regulated and regulator, that’s a problem, but the implications that has for financial stability that you don’t have in any other sector. If you regulate utilities or you regulate any other manufacturing type of industry, or any kind of services apart from finance, bad things can happen in terms of society paying a higher price for something. But you can’t build up the sort of risk that will bring down the world economy. At least that hasn’t happened to my knowledge any time in human history previously.

But the financial sector repeatedly blows itself up. And the more you let them capture the regulators, the bigger they’re allowed to become in that captured mode, capturing mode, the more danger you face at the end.

Knowledge@Wharton: So you say that it takes a long time to turn a ship around like that. It takes years of, I guess, hammering away in order to make progress against what you see as these big problems. How do you see this most likely playing out? On the one hand, you say we’re likely to have another financial crisis, although I don’t think you’re willing to predict exactly when. But on the other hand you hold out this hope that public consciousness could change, public opinion could, change; it’s a matter of years. You point out that in the Depression after the crash, it took many years to get the kind of banking legislation which held up and supported a very strong economy for a third of the century. So what do you see happening?

Johnson: Well, I hope that we have a Teddy Roosevelt-type experience. The Sherman Antitrust Act was passed in 1890. It was not used against excessive corporate concentration of power or market power until Roosevelt seized the opportunity. In 1901, a very large monopoly was formed by JP Morgan and his associates, a railroad monopoly in the part of the country that you called Northern Securities. Roosevelt saw this as an opportunity to try and break that trust and other trusts. He brought a suit against Northern Securities. In early 1902, JP Morgan came to see Roosevelt at the White House. According to the record, he said, “If we’ve done anything wrong, send your man to see my man and we’ll fix it up.” And Roosevelt, thank goodness, said, “No. We don’t want to fix it up. We want to stop it.” And he did.

In the 10 years that followed, from 1901 to 1911, the mainstream consensus on the issue shifted. In 1901, most people thought Roosevelt was a little bit crazy for doing this. They didn’t understand the logic. The idea that there was such a thing as monopoly and monopoly power that should be addressed was not a mainstream consensus idea in the United States. By 1911-1912, breaking up Standard Oil, the most powerful company in the history, certainly of this country — that was not controversial. It was broken up in great American style so that all the shareholders made money and John Rockefeller and his family rehabilitated themselves in the eyes of the American public with great acts of generosity. That’s what we should be looking for, that kind of opportunity. Because if you don’t take that opportunity, you’ll face what FDR faced in the early 1930s when everything was broken. Then sure, there’s a consensus for change. But at what cost?

Knowledge@Wharton: So it’s a classic human nature scenario where you can’t get a traffic light at an intersection until there’s been some serious accident.

Johnson: I am asking the D.C. government to address an issue, an intersection near my house. And they will not pay attention because they are distracted. I fear it’s not just human nature; it’s the nature of human organizations and the way we run our society that very much works in this direction.

Knowledge@Wharton: So based on some of the things we’ve talked about, are you expecting a lot more volatility in the economy? You talked about recessions, meta-booms. It sounds like you’re predicting a lot of volatility to me.

Johnson: Yes, I think this is a recipe not for stagnation. I know that a lot of people are pessimistic, a lot of people are worried about the job market going forward, and that’s understandable on a short-term basis. But the conditions that I’m describing and the incentive schemes that have been put in place point towards a boom, a global boom, a boom perhaps centered around emerging markets, but with these massive “too big to fail” American, and European by the way, banks at the center of the action, again.

If you remember, in the 1970s there was a so-called recycling of oil money.

Knowledge@Wharton: Petrol dollars.

Johnson: Petrol dollars. The oil countries had large current account surpluses. They parked those with banks in London and in New York. Those banks, for example, Citibank, lent those dollars to Latin America and to Communist Poland and Communist Romania. That ended very badly in 1982. So repeating some version of a global cycle like that strikes me as the most likely outcome.

The 1920s, of course, were terrific. There was a transformation of the American economy. There was a growth of the middle class, the automobile industry took off, and there were real productive changes. Finance played a constructive role there, but finance also got out of control. The big banks went into securities trading, a business they didn’t understand, and they didn’t know the risks they were taking. They abused a lot of customers, by the way. They lured them into products they didn’t understand. But the heart of the problem in 1931, 1932, and 1933 was that the major banks had taken risks onto the balance sheet that they didn’t understand and they were essentially insolvent. Some of them failed; some of them were saved. The rest of the system also suffered calamity under those circumstances. Let’s not do that again. But that’s where this is pointing.

Knowledge@Wharton: What haven’t I asked you that I should have and that you would like to tell us about?

Johnson: There’s a great deal of discussion right now in America about fiscal responsibility. I just cannot take anybody seriously who wishes to discuss this issue without putting the financial sector front and center. As a matter of historical record, just look at the Congressional budget office data, uncontroversial in this point. The increase in government debt, net government debt held by the private sector, started out around 41% of GDP. It’s on its way to 70% – 80% of GDP, roughly doubling. That increase is due primarily to the financial crisis.

It’s not, by the way, the result of the fiscal stimulus even. Most of that increase is just because, when you have a big recession, you pay unemployment benefits to people and you collect less tax. Nobody in my mind can be taken seriously if they wish to discuss bringing the U.S. debt under control unless and until they’re willing to deal with these financial sector issues that again threaten to completely destabilize both our economy and the fiscal soundness of the government.

Knowledge@Wharton: Those wouldn’t be naturally linked in the public’s mind though. Explain why they should be.

Johnson: Well, look, I testified to the Senate budget committee on these issues and related issues recently. The reaction among the Senators who were present, and I must say from left and right there were very responsible, sensible people there for whom I have a great deal of respect, was that they felt that they already have enough on their plate, that they already have difficult enough problems. I respect that. I’m very sympathetic to that. But this is where you need leadership. This is where you need someone who goes out and explains it to people. And the data are not controversial.

I’m on the panel of economic advisors for the CBO [Congressional Budget Office]. So these are their data, not my data. I am explaining them to you. But what you need is a political leadership that gets this, that is willing to go out and explain to people where this fiscal problem came from and where it’s going to go. Otherwise, you’ll end up like Ireland. Otherwise you’ll let the banks get too big. The banks will fail. They’ll ruin you fiscally. Ireland was considered to have a very responsible fiscal policy prior to 2008. It didn’t because of the hidden vulnerability, people call it contingent liability, the money they owed, the money they were going to provide in the event of this financial failure. Why should we go there? Why would we ruin ourselves in that way? Makes no sense.

Knowledge@Wharton: Thank you so much for joining us.

Johnson: Thank you.

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