This is the first in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. We heard presentations from speakers like Simon Johnson, Elizabeth Warren and Joseph Stiglitz and heard comments during Q&A from George Soros, Stanley Sporkin and a host of other noted figures.
What is the doom loop?
It is the unstable, crash-prone boom-bust lifestyle we have now been living for some 40 years, where a cycle of cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts. With interest rates near zero everywhere, the doom loop seems to have hit a terminal state where debt deflation and depression are the only end game unless serious reform measures are taken.
Source: The doomsday cycle, Peter Boone and Simon Johnson
Because these measures themselves are deflationary and depressionary (with a small-d), in my view, they will not be taken.
Johnson sees large too-big-to-fail banks at the heart of the problem. Citigroup has been at the center of every major crisis. That is testament to both how important and how dangerous these companies can be. Clearly, these companies are important. For example, the big six banks (JPMorgan Chase, Wells Fargo, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley) own assets equal to 60% of U.S. GDP where it was 20% just a few decades ago. This makes these organizations too big to fail and affords them an implicit federal backstop which tilts the playing field by translating into cheaper funding costs.
Johnson had two great charts I wish I could re-produce here. The first showed indexed real corporate profits over the past few decades in the financial and non-financial sectors of the economy. What you saw was an enormous divergence that coincided with the deregulation movement in the early 1980s, with the financial profits index soaring well in excess of everything else. It came crashing down in 2007, but has since reassumed its enormity.
The second chart showed you relative wages in the financial and non-financial sectors since the turn of the 20th century. What you saw was an explosion in financial sector wages in the 1920s and then a crash down to earth in the 1930s, after which it flat-lined. Then, relative wages exploded again in the 1980s in exactly the way they did right before the Great Depression. The cheap money and financial rewards increased the appetite for risk, leading to a crisis.
In this particular cycle, Johnson says privately-held debt in the U.S. will increase by 40 percentage points of GDP as a direct result of measures (automatic stabilizers, bailouts, stimulus, etc) used to clean up the mess. That is an enormous societal burden which represents a socialization of losses – a direct transfer from you to the banks.
Johnson’s solution is to break up the big banks and to break their political power as well.
My view is this: the banks will not be broken up because the moment for reform has temporarily passed; the banks are too ingratiated into the system to break them unless we are in the midst of a serious downturn. When Obama continued the Bush policies and bailed out the banks in early 2009, the chance for serious reform ended.
However, as I see it, the Doom Loop is very much still operational. And that necessarily means another crisis down the line. However, given short-term interest rates are at zero percent I suspect we will reach the end of the line at that juncture. This is when true financial reform will come.