Arrogance and Authority
Simon Johnson
Project Syndicate
2011-04-26
http://www.project-syndicate.org/commentary/johnson19/English

WASHINGTON, DC - It is increasingly common to hear
prominent American and European central bankers
proclaim, with respect to the crisis of 2008-2010, the
following verdict: "We did well." Their view is that the
various government actions to support the financial
system helped to stabilize the situation. Indeed, what
could be wrong when the United States Federal Reserve's
asset purchases may have actually made money (which is
then turned over to the US Treasury)?

But to frame the issue in this way is, at best, to
engage in delusion. At worst, however, it creates an
image of arrogance that can only undermine the
credibility on which central banks' authority rests.

The real cost of the crisis is not measured by the
profit and loss statement of any central bank - or by
whether or not the Troubled Asset Relief Program (TARP),
run by the Treasury Department, made or lost money on
its various activities.

The cost is eight million jobs in the US alone, with
employment falling 6% from its peak and - in a major
departure from other post-1945 recessions - remaining 5%
below that peak today, 31 months after the crisis broke
in earnest.

The cost is also the increase in net federal government
debt held by the private sector - the most accurate
measure of true government indebtedness. Comparing the
US Congressional Budget Office's medium-term forecasts
before (in January 2008) and after the crisis, this debt
increase is a staggering 40% of GDP.

Indeed, the reason there is a perceived fiscal crisis in
the US today - along with spending cuts that will
further hurt many people - is simple: the banks blew
themselves up at great cost to the American people, with
major negative global implications. Most of the public-
debt increase in the US and elsewhere is not due to any
kind of discretionary fiscal stimulus; it's all about
the loss of tax revenue that comes with a deep
recession. (And the Bush administration's tax cuts for
the wealthiest, unfunded Medicare prescription benefit,
and debt-financed wars in Afghanistan and Iraq have
severely weakened the long-term fiscal outlook.)

Finally, the cost of the crisis is millions of homes
lost and lives damaged, some permanently.

The issue is not whether the Fed, or any central bank,
should seek to prevent the collapse of its country's
banking system. To see the severe effects of a banking
crisis, look no further than the 1930's, a period that
Ben Bernanke studied in detail before he became Fed
chair. If the choice at any particular moment is to
provide support or let the system collapse, you should
choose support.

But, more broadly, as Dennis Lockhart, President of the
Atlanta Federal Reserve Bank, said last week at a public
conference organized by his institution, we should not
seek to operate a system based on the principle of
"private gains and public losses." And these losses are
massively skewed in ways that are grossly inefficient,
in addition to being completely unfair.

The private gains can be measured most directly in the
form of executive compensation. From 2000 to 2008, the
people running the top 14 US financial institutions
received cash compensation (salary, bonus, and the value
of stock sold) of around $2.6 billion.

Of this amount, around $2 billion was received by the
five best-paid individuals, who were also central to
creating the highly risky asset structures that brought
the financial system to the edge of the abyss: Sandy
Weil (built Citigroup, which blew up shortly after he
left); Hank Paulson (greatly expanded Goldman Sachs,
lobbied for allowing more leverage in investment banks,
then moved to the US Treasury and helped save them);
Angelo Mozilo (built Countrywide, a central player in
irresponsible mortgage lending); Dick Fuld (ran Lehman
Brothers into the ground); and Jimmy Cayne (ran Bear
Stearns into the ground).

The public losses are massive in comparison: roughly $6
trillion, if we limit ourselves just to the increase in
federal government debt. And leading bank executives
still insist that they should be allowed to run highly
leveraged global businesses, in which they are paid
based on their return on equity - unadjusted for any
risk.

The world's top independent financial minds have looked
long and hard at these arrangements, and, given what we
have learned in recent years, have found them worse than
wanting (see the Web page of Anat Admati at Stanford's
Graduate School of Business for the details). In their
view, the big banks should be funded much more with
equity - perhaps as much as 30% of their capitalization.
But bankers strongly reject this approach (because it
would likely lower their pay), as do central bankers
(because they are too much persuaded by the protestation
of bankers).

There are many advantages to having an independent
central bank run by professionals who can keep their
distance from politicians. But when the people at the
apex of these institutions insist that the crisis
response went well, and that everything will be fine,
even as the financial behemoths that caused the crisis
lumber forward, their credibility inevitably suffers.

That should worry central bankers, because their
credibility is pretty much all they have. The US
Constitution, after all, does not guarantee the Fed's
independence. Congress created the Fed, which means that
Congress can un-create it. By assuming away the damage
that highly leveraged megabanks can do, the myth of a
"good crisis" merely makes political pressure on central
banks all the more likely.

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