Blogs: Robert Johnson

Why this crisis is far from finished

Robert Johnson — Fri, 25 Apr 2008 12:16:58 -0400

The article below from the Financial Times discusses the propagation of the credit crisis from Wall Street to Main Street. Even though the breathtaking disaster headlines have evaporated, the unfolding of this crisis is eroding living standards below the surface.

The financial markets are rallying and many leading investment bankers are declaring that the crisis is over. They do protest too much, methinks. Trying to buy time, politicians, financiers and policy makers are trying to fight "fear itself" and put the financial markets onto a more positive trajectory. In a sense we all benefit from that as they raise capital for the financial institutions. Either assets are sold or capital is raised to reduce leverage ratios. The latter is preferable for us all.

At the same time, there will be a creeping awareness that Wall Street is not self-contained. That their crisis is now in slow motion rather than hyper-speed does not mean that Main Street will not now feel the crunch that results from Wall Streets excesses.

Wall Street sets the rules for this game with its lucrative financial contributions to politicians. It is hard to fix the rules in the middle of the crisis in any event. Yet I remained concerned that the real efforts to fix these structural flaws in our market systems will take place after the election, when the importance of people/voters is diminished relative to the role of money and so-called "expertise". That demoralizing process is likely to unfold when the propagation from Wall Street to Main Street is evident to us all and the pain of still further declines in living standards of the American population cannot be denied.

It will take a great deal of will to address this challenge. Efforts will be made to declare financial regulation too complex for the lowly population to have a voice. Let us hope that progressives will increasingly see the role of the economic structure in their plight and not submit to this "tyranny of expertise" as Naomi Klein calls it, when the rules that govern our society are revised.

Why this crisis is still far from finished

By Mohamed El-Erian
Published: April 24 2008 19:24

During the past few weeks we have seen a growing number of market participants predict an end to the dislocations that erupted last summer and claimed victims throughout the financial system and beyond. While their predictions are understandable, they are premature. The dynamics driving the disruptions are morphing and may again move ahead of both the market and policy responses.

The optimistic view is based on two distinct elements. First, that the de-leveraging process is reaching its natural end as valuations stabilise and institutions come clean about their losses and raise capital; second, that a series of previously unthinkable policy responses have been effective in restoring liquidity to the financial system.

Both views have merit. Financial institutions, particularly in the US, have recognised the scale of the problem and are taking remedial steps. Just witness the recent round of capital raising by Citigroup, Merrill Lynch, JPMorgan and Wachovia. At the same time central banks in Europe and the US have opened up their financing windows, expanding the size of the financing, the range of institutions that can access it and the list of eligible collateral.

Yet, consistent with what we have seen since last summer, the dislocations are entering a new phase. As such, bold reactions on the part of policymakers may, once again, prove to be too little and too late.

Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.

Economic data in the US have taken a notable turn for the worse. Most importantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

Pity the US consumers. Their ability to sustain spending is already challenged by the declining availability of credit, a negative wealth effect triggered by declining house values, and a lower standard of living as the result of higher energy and food prices and a depreciating dollar. Job losses will accentuate the pressures on consumers, leading to income declines and a further loss of confidence.

While the financial system has taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks.

It is thus too early to declare the end of the turmoil that started last summer. Instead, during the next few months we may witness a new phase of dislocations, led this time by the real economy. The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activities within the banking system and beyond.

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve’s dual objectives – maintaining price stability and solid economic growth – will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse.

It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.

Why Financial Regulation is Essential

Robert Johnson — Thu, 17 Apr 2008 12:34:20 -0400

The Financial Times article by Martin Wolf illustrates that a man who has alway been pro market can see the problems with no regulation and self policing of markets. While Wolf is right to point out that regulation and enforcement are also human activities that can generate their own follies, the work of the society is to set rules to protect people from the excesses of a given segment of society while maintaining the maximum freedom of those within the sector to be creative.

All agree now that:

Risk management is appalling.
Executive Compensation Incentives matter.
Enhancing transparency is vital.
Leverage is extreme.

What is not envisioned yet is how these changes will be made by a political system that is so dependent upon the campaign contributions from Wall Street. Self regulation is not viable. Having the market participants make the rules for themselves through legislative proxies who they fund is not much better. What is essential to this process is citizen scrutiny and participation. Citizens must blast through the tyranny of expertise that is used to intimidate them from participating in that which impacts their lives profoundly. They should also recognize that after the election the influence of voters will diminish for a couple of years.

Wolf quotes Willem Buiter, the sharp witted economist from the London School of Economics on self regulation.

“Self-regulation stands in relation to regulation the way self-importance stands in relation to importance.”

The remaining question is about citizen action in the USA. Are we self respecting enough to exert the will and effort to take on the self important and implement a system of sound regulation. Right now the betting is still on the money rather than the population. What are we going to do about it?

Why financial regulation is both difficult and essential
By Martin Wolf, Financial Times
Published: April 15 2008

Nice try; no cigar. That was my reaction to the attempt of the banking community to forestall additional regulation, by recommending “a suite of best practices to be embraced voluntarily”. It was also the reaction of the policymakers meeting in Washington over the weekend. More regulation is on its way. After frightening politicians and policymakers so badly, even the most optimistic banker must realise this. The question is whether the additional regulation will do any good.

In an interim report on “market best practices”, the Institute for International Finance, an association of bankers, offers devastating self-criticism.* Here then are some of the weaknesses it identifies: “deteriorating lending standards by certain originators of credit”; a “decline of underwriting standards”; an “excessive reliance on poorly understood, poorly performing and less than adequate ratings of structured products”; and “difficulties in identifying where exposures reside”. Would you buy a voluntary code from people who describe their own mistakes in this brutal manner? I thought not. There are two powerful additional reasons for not doing so

First, in such a fiercely competitive business, a voluntary code is almost certainly not worth the paper it is written on. When they can get away with behaving irresponsibly, some will do so. This puts strong pressure on others. That is what Chuck Prince, former chief executive officer of Citigroup, meant when he told the FT that “as long as the music is playing, you’ve got to get up and dance”. So, as Willem Buiter of the London School of Economics remarks: “Self-regulation stands in relation to regulation the way self-importance stands in relation to importance.”

Second, the industry has form. The IIF itself was founded in 1983 in response to the developing country debt crisis. At that time, big parts of the west’s banking system were in effect bankrupt. Now, many upsets later, we have reached the “subprime crisis”. The IIF was created not only to represent the industry, but to improve its performance. It is clear that this has not worked.

Do not just take my word for it. Last month, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard published an extraordinary paper on the long history of financial crises.** The chart shows that the incidence of banking crises (measured by the proportion of countries affected) has been as high since 1980 as in any period since 1800; that the incidence of crises is correlated with liberalisation of capital flows; and that there was, until 2007, a decline in the incidence of crises in the 2000s.

Yet why, I ask, should this industry have apparently failed to improve its standards of performance over the past century? After all, almost every other industry has done so. Consider how confident we are that the food we buy will not poison us. Yet adulterated food was once a threat.

Consider, by those standards, the failures of the banking industry, as admitted by the IIF itself. Its purely operational performance is now impressive. But competition does not work well in finance. The “product” of the financial industry is promises for an uncertain future, marketed as dreams that can readily become nightmares. Customers are readily swept away by exaggerated promises, irrational beliefs, misplaced trust and sheer skulduggery. So, too, are practitioners: basing risk management on limited data and inadequate models is a good example. Emotions count wherever uncertainties loom.

Crisis on Wall Street - Shock Doctrine Opportunity - Notes from Take Back America Panel

Robert Johnson — Thu, 27 Mar 2008 13:17:50 -0400

Originally posted at Firedoglake.

The crisis on Wall Street appears to be very severe. The Federal Reserve's emergency actions, background discussions with foreign central banks about outright purchase of mortgages, and the premiums on interbank interest rates over Treasury Bills (The so called Ted Spread) suggest that fear of credit collapse is significant. As a result "the rules of the game" are in play.

Naomi Klein, in her recent book, The Shock Doctrine, addresses the strategy of response to crisis. She cites Milton Friedman who once wrote:

only a crisis-actual or perceived-produces real change. When the crisis occurs, the actions that are taken depend on the ideas lying around. That is our basic function: to develop alternatives to existing policies, to keep them alive, and available until the politically impossible becomes the politically inevitable. (from Capitalism and Freedom)

I would argue that the Wall Street meltdown and its shocking consequences will create the crisis conditions that are ripe for change. Albeit, Dr. Friedman had the opportunity to enact change because he often promoted ideas particularly suited to the wealthy and the powerful. Yet it is those ideas, largely underpinning the policies of the last 40 years, that are now called into question. Therein lies the opportunity.

The response to the Wall Street shock will have to, as Thomas Palley wisely suggests, be carried out on two fronts. One is policy. But policies must be justified with sound underpinnings. The extent of this crisis is likely to lead to reexamination in a cold critical light of ideological premises where the neoliberal ideas of free market fundamentalism will be shown to be in sharp contrast to the corporatist practice of the United States. As the Wall Street crisis deepens and spreads, the bailout will contradict the notion of a separation between state and market. Seen from the light of the financial crisis, other violations of market fundamentalism will be scrutinized. State support for military, oil, telecommunications, finance, and more belie the notion that there are clean boundaries between markets and politics. We will increasing realize that we have never been in that dream cloud where markets went unsubsidized.

In another instance, the market fundamentalists have gotten great traction from the "Horatio Alger" mythology of the self made man. Individual responsibility is the key to success, they say. That is an attractive notion. It seems to suggest that one has power to control one's own destiny. While I would never want argue that effort and self discipline are not helpful or necessary components of success, I would argue that context also matters. In the present crisis it is very likely that a multitude of hard working, disciplined and well educated people are going to be blown off their moorings as a result of the fallout from Wall Street. Things beyond their control are going to hurt them. Things that other people were allowed to do.

As a result, the experience dreadful outcomes in our society are likely to illustrate that the attraction of Horatio Alger mythology is illusory. Anxiety is reduced if you feel you have power over your environment. The protection of those beliefs is shattered when activity in society, over which you have no influence, overwhelms your life and livelihood.

Naomi's book illuminates many episodes where the wealthy and the powerful take advantage of crisis. The raising of consciousness about the process of change is a gift she gives us all. Yet I would augment that perspective with the awareness that the New Deal was also a response to shock. A response that was progressive in orientation. A response born of extreme pain, yet one that did usher in a more prosperous and stable era in the U.S. economy. Growth was higher, the economy more egalitarian, and volatility was lower than in the period since 1980. (See Peter Lindert's book entitled Growing Public for factual data)

It appears that the forces of change will do battle in the coming months. On the one hand a quick look at the Federal Election Commission data for our three Presidential candidates suggests that there may be one too many markets in America. The market for the rules of the game is one where Wall Street plays a leading role. (See http://www.opensecrets.org/pres08/index.asp) On the other hand votes do matter this November. On that one day they are the ultimate currency.

At the present time many sophisticated social leaders from days past, including Paul Volcker and Robert Rubin are, in my opinion rightfully, saying that we will have to resort to the Federal balance sheet and a public bailout. Wall Street took action, including spending many millions of dollars over the years to unshackle themselves from New Deal constraints on financial intermediaries, and we must pick up the losses. From this vantage point we are in a lose-lose game and in the short term our task is to mitigate unnecessary losses. It appears to me to be inevitable given the scale of the problem. The question will be what are the changes in the rules that will accompany the bailout? Who will make these rule changes so that we do not come back this way again. So that trust in our financial system is renewed.

We have a highly combustible societal cocktail brewing The combination of 1) what Sarita Gupta and David Sirota perceive, of rising awareness and mobilization, which we might call the Pissed OffPeoples Party (POPP); 2) The need for a bailout; 3) Wall Street money all over the candidates and Congressional Committees; 4) The refutation of the safety of Horatio Alger; and, 5) the temptation for financiers to suggest that financial issues are "too complex" foranyone but the experts (who made this mess) to rectify the system; combine to make for a very anxious process.

As the process unfolds, awareness of these tensions suggests we are likely to see efforts to:

Move the bailout underground along the lines suggested in the Financial Times on Friday where a Committee of Central Banks around the world would buy mortgage backed securities.
See repeated warnings (likely to be heeded by the political candidates) that anything they say will deepen the crisis in the markets.
Disenfranchise some stakeholders in our social design on the grounds of expertise. Expertise that is needed to comprehend these arcane instruments and their role in the seizing up of our financial system because of fears of counter party default.
Berate those who unmask market fundamentalism as socialists or utopians and avoid the contradictions that are apparent to all.

I do not at present see effective countervailing power that will focus the energy of the POPP into action. Organizations to represent this energy are likely to include some strange bedfellows. Independent bankers who are not "too big to fail" may want to participate. The labor movement can play a role. But right now the forces for progressive change are somewhat scattered.

It may be that the progressive effort to organize is too diminished and weak to make a difference to the outcome resulting from this crisis. The energy is felt, but cannot be productively channeled to overcome resistance and introduce constructive change in this iteration. In that event we are likely then to have shattered neoliberal ideology and still have neoliberal remedies adopted. In that event the unfolding events will deepen the anger within the POPP and inspire organization for future challenges.

At very least, I imagine the public will come to wish we had public financing of elections as they experience the questionable rules that will emerge from the current political incentive structures in response to the crisis on Wall Street. Second, because they will look at the bill and realize that they could have avoided this catastrophe and had strong infrastructure, schools, and health carefor what they spent bailing out our financial system in response to the current challenge.

Robert was formerly chief economist to the Senate Banking Committee and also former Managing Director of Solos Fund Management.