In part two of an interview with Simon Johnson, the former IMF chief economist looks at problems brewing in emerging markets, which have “gone crazy borrowing in foreign [currencies].” He also weighs the different approaches bank regulators take in the U.S. versus Europe. “In Europe, they’re still shell shocked from the sovereign debt crisis [and] very scared of doing anything that would destabilize … their recovery. As a result, the bankers are able to dictate the terms to the regulators.” Johnson also expresses skepticism at the idea that national banking regulators will look after each other’s interests during a crisis.
An edited transcript of the conversation follows:
Knowledge at Wharton: [A recent] Martin Wolfe column in the Financial Times ended with a recommendation [similar to the one] you were making — that Europeans should be upping equity requirements rather than the road they’ve gone down, or in addition to the road that they’ve gone down.
There’s the state of mind of the regulators, and then there’s whether they actually have the resources to do it, even if they had the will. Where do the resources come from? You said the 60 billion euro is too small … relatively speaking to the problem. How would you evaluate the resources that are being thrown at this issue?
Johnson: I think the main resource is one of legal authority. And also … the intellectual dimension. Do the regulators have a sufficiently skeptical view of these large complex financial institutions? Do they force them to simplify? Do they require more safety measures, such as larger buffers of equity, which is by far the most important issue right now? How do the regulators see this? Do they have the legal powers to push for the right kind of changes?
In the U.S. they do. In Europe, they’re still acquiring those powers. I think intellectually there’s a split within the U.S. official community. But the people in favor of making the system safer and more resilient have a slight upper hand at the moment. It may change. I may regret saying this, but that’s the current direction — a little bit encouraging.
In Europe, not so much. In Europe, they’re still shell shocked from the sovereign debt crisis, and they are very scared of doing anything that would destabilize, in their view, their recovery. As a result, the bankers are able to dictate the terms to the regulators. So, I don’t think it’s a lack of resources, per se; it’s a lack of intestinal fortitude. But you have to understand that in the broader European context — with the macro economic problems — it’s hard not to be somewhat sympathetic to the regulators.
Knowledge at Wharton: You have different approaches on different sides of the ocean…. In a real crisis, there are no borders, and there’s contagion and all the rest of it. So … if there’s a problem … how do you resolve this? It may be a U.S. bank, but they have enormous holdings overseas…. I know there have been moves for cooperation across the ocean, but where does that stand? And does this recent European legislation change that state of cooperation or improve it in some way?
Johnson: The Europeans are trying to get better cooperation for resolution within the euro area, which would be a very important step.
Knowledge at Wharton: That’s the bank union step?
“It’s an awful lot to bet on regulators and liquidators treating each other in a pleasant way: British regulators looking out for American interests? Why would they look out for American interests?”
Johnson: Well, it’s part of the banking union. Banking union has many dimensions — agreeing to have a common approach to resolution, a common resolution framework, clear rules for sharing the losses depending on where the activities are and what went wrong in the bank. I think we’ll only believe it when we see it — when we actually see one or more banks go through that.
But they definitely understand that they need to move in that direction. The big issue is the cross border piece between the U.S. and the U.K., the U.S. and the eurozone, the U.S. and other jurisdictions, and of course between all these jurisdictions — between each other. That remains really problematic. There are not binding agreements on how to handle it.
We have some memos of understanding. And there is some, perhaps, better communication [than] in August and September 2008. But we haven’t stress tested that. We haven’t seen it under pressure. And we haven’t seen what happens when, as you said, a large American bank that has a big operation in the U.K. is in trouble. Do the U.K. authorities move to seize assets because they’re concerned [about the] abilities [of that bank] in the U.K.? [Do] they move to seize those assets in the U.K.? Or are they comfortable with some of those assets coming back to the United States as part of an integrated resolution in the U.S., believing that value will be available to satisfy creditors and other counterparties in the U.K.? That’s a very complicated and delicate matter. And I really don’t think it’s all sorted out.
Knowledge at Wharton: After the Asian financial crisis in the 1990s, there were a lot of agreements among countries to have cooperation when it came to foreign exchange, because that started out as a foreign exchange panic or crisis. But that wasn’t the problem that came up in 2008. And the next crisis, whenever it might be, we don’t know how it will start. Can you describe what steps have been taken that might help with this cooperative effort that could be effective, between say Europe and the U.S. or other banks in Asia and so forth?
Johnson: Well, the main steps that have been taken are in the form of these statements of agreement of principle. The Bank of England has said they understand what the FDIC would do in the event of a crisis here. And they appreciate that that could well be the right approach for the bank on a global basis.
From the point of view of what matters in a crisis, it’s all a bit loose. And you’re relying on a lot of good will. There will be, remember, enormous time pressure when these crises develop. Big decisions have to be made in a 24-hour window, if not faster. And it’s an awful lot to bet on regulators and liquidators treating each other in a pleasant way: British regulators looking out for American interests? Why would they look out for the American interests? Or Koreans looking out for American interests? Their job, their responsibility — in some countries it’s a legal responsibility — is to look out for their own citizens, their own exposure and their own taxpayers’ potential losses.
So it’s very hard, unless you have a binding treaty. Unless the countries were actually writing down what they would do, when and how, I don’t think you’re actually ever going to get there.
Knowledge at Wharton: You make an appearance in a book written by Jeff Connaughton — The Payoff: Why Wall Street Always Wins.
He’s a former lobbyist and Congressional staffer. So he’s got a view of both sides of the street. And he gives a pretty devastating look at the inner workings of Congress and the influence of Wall Street lobbyists, and money and fund raising and so forth. I know that you were working with former Senator Ted Kaufman to try to add some more bite to some of the financial legislation. Some of it made it through, but a lot of it didn’t, at least what he and [Senator] Sherrod Brown wanted to do. It is now probably two years since the book was written. Has much changed since that time in regard to the issues that were discussed in the book?
Johnson: I think Jeff’s points about the structure — the influence industry around Wall Street — are now just as true as they were then. What has changed is that the crisis woke people up and people began to realize that just allowing the financial sector, including big banks, to do whatever they want, any kind of innovation, any kind of change in their size and structure — this was not necessarily good for economic growth, not necessarily good for the rest of the economy. And the notion of systemic risk, I think, is very much on the minds of many officials.
Sometimes these banks can get big enough and leveraged enough so they cause danger to the financial system. And that can have big negative effects. Even if you avoid a Great Depression you can have a Great Recession, and you can lose more than 8 million jobs and struggle to come back five, six years down the road.
What’s changed a little bit is there’s no more of a push back against the influence industry. Now they’re very powerful. They have a huge amount of money. They put money into explicit lobbying, but also in many ways they can influence opinion in and around Washington, primarily, and also around the country.
There are more people concerned about that, more people pushing back and more officials inclined to push back now. So, the outcome of the process of financial reform, I think, remains in question. But I am a little bit more encouraged than somebody might have been just after reading Jeff’s book, for example. I think it’s not over, and it’s not a foregone conclusion that the same dangerous power structures prevail as before.
“The outcome of the process of financial reform, I think, remains in question. But I am a little bit more encouraged…. It’s not over, and it’s not a foregone conclusion that the same dangerous power structures prevail as before.”
Knowledge at Wharton: What’s your latest project?
Johnson: I’m interested in the history of bailouts. I think we have a long history of protecting individuals, protecting different kinds of firms in various settings in the United States and in the Western tradition. But we’ve changed over time a lot. The terms of the bailout, what you need to do in order to get it, who we regard as being critical, what justifies a bailout — I think that’s an important story to tell people, preferably in a relatively gripping way, because there’s lots of drama. There are lots of compelling individual characters.
Knowledge at Wharton: The latest being maybe the U.S. auto companies?
Johnson: Yes, absolutely. Auto companies. But also the banks and the financial system going forward. Because sometimes you get the impression when you listen to, I don’t know, a top official at the Federal Reserve, that a certain set of activities will be bailed out because that’s what the science says. And everything else is on its own. In fact, it’s much more of a give and take, and it’s much more about a sequence of events and what particular individual’s in the hot seat at the moment. What did Hank Paulson want to do? Why did he do it? Tim Geithner also is a fascinating character. A lot of decisions made in these periods of turbulence are huge.
It’s better to have a more open debate and discussion about the nature of bailouts. When does a bailout make sense, and when does it not make sense? It’s better to have that discussion now in a period of relative calm than to try and have it on a Friday night when you know that you have to make a decision one way or the other by Sunday evening before the Tokyo market opens. So that’s what we’re trying to do.
Knowledge at Wharton: When should there be bailouts, and when shouldn’t there be?
Johnson: Well, I think the answer depends on how you define the national interests and the nature of — in economist jargon, externalities.
Knowledge at Wharton: So how many jobs are affected?
Johnson: Well, the externalities, yes. And what’s interesting about the United States, and a big advantage we have relative to a lot of countries, is we have a relatively efficient commercial bankruptcy procedure. Meaning the bankruptcy process through which firms have to go doesn’t destroy a lot of value. In some countries it does destroy a lot of value. In the United States, the value of the firm may well be heading down before you go to bankruptcy, but the act of actually going through Chapter 11 or some other part of the bankruptcy code — even liquidation — that act doesn’t reduce the value in a discreet way. And you can often come back out of bankruptcy, which is a remarkable American phenomenon, I must say.
So we can do that for some firms. Now we didn’t do it for the auto firms. That’s very interesting and important. We didn’t do it for the airlines after 9/11, by the way, because of what were regarded to be important overriding interests there. They got some additional support. And we didn’t do it for the big banks in 2008/2009.
Now I think it’s a fair question: Would you do it again for General Motors? If not, why not? Would you do it again for J P Morgan Chase? If not, why not? I think those are very interesting and important questions to debate now and to have a much broader understanding. Don’t let the technical experts decide it in a dark room.
Knowledge at Wharton: What else happening on the world stage in finance would be important to think about?
Johnson: I think emerging markets are lining themselves up for more problems. The official sector has been relatively restrained in terms of borrowing through the latest cycle. But the up-and-coming globalized multinationals from some of these countries have gone crazy borrowing in foreign exchange.
“The terms of the bailout, what you need to do in order to get it, who we regard as being critical, what justifies a bailout — I think that’s an important story to tell people.…”
If you remember back to what we might consider to be the first modern emerging market crisis, which was Chile at the end of the 1970s — 1982 is when it really got bad — most of the debt taken on in Chile in foreign currency in dollars was by the private sector, not by the government. It became a public sector responsibility. There was a form of bailout, if you like, a very messy form.
But it was private borrowing. And I think that there are some people in emerging markets — India would be one country that springs to mind – [who] have forgotten that. They think that as long as the public sector remains relatively restrained and we don’t have a lot of foreign-currency-denominated debt on our balance sheet in the government sector, we’re OK. But foreign-currency-denominated debt held by the private sector or issued by the private sector can also be very damaging.
That’s what happened in the Asian crisis 1997-1998. In Indonesia, Thailand, Korea, the main problem was that the corporates had borrowed either overseas or in mostly in dollars, not that the government had. But then it becomes a government responsibility, and the government has to take steps to try and stabilize the macro economy when that debt turns against you.
Knowledge at Wharton: So the same is true for Ireland and Spain, is it not, for the recent financial crisis — mostly private debt taken over by the government.
Johnson: Yes, but the important difference maybe is that it’s in euros, right? So it is their currency — it’s not a currency controlled by the Central Bank of Ireland, Central Bank of Spain, it’s controlled by the Central Bank of Frankfurt.
And you might also argue it’s actually more difficult to get out of the Irish/Spanish/Greek version of this debt crisis because your currency doesn’t depreciate. You can’t become more competitive relative to countries with which you’re competing. You’re stuck at this same exchange rage. Wages and prices can change, but that’s a relatively painful adjustment process. But you’re absolutely right: It was private borrowing in Ireland and Spain. And that makes them different from Greece.
Knowledge at Wharton: In Asia, then, because they had their own currency, as painful as it was and as big as the drops were, they bounced back relatively quickly compared to what’s happened to places like Spain and Ireland, which are still struggling with very high unemployment.
Johnson: That’s exactly right. Now they have a different structure of the economy. They were much more export-oriented in Thailand and Indonesia and Korea, for example. But the recovery was absolutely without question faster than what we’ve seen in most of Europe. And it was in part because of the depreciation of the currency. Iceland would be another case. Very traumatic. Nothing nice about the Icelandic crisis. But the depreciation of the currency has played a role in facilitating a better recovery than what otherwise might had been the case.
Knowledge at Wharton: They took over their banks too, didn’t they — the government [in Iceland]?
Johnson: There was no alternative. The banks defaulted first. And then the defaulted banks were taken over. So the debt, which was at least 11 times GDP, was written down massively. The government went from being a low debt government to a relatively high debt government. But the debt burden is manageable because they wrote it down before the government takeover.