On April 1st 2012, my book,”Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

The U.S. currently has a handful of “too-big-to-fail” banks. What does this mean?

It’s not for nothing that Ben Bernanke, chairman of the Federal Reserve, considers the fact that the U.S. currently has a handful of TBTF banks “as one of the country’s most serious problems.” He is quite right.

The arguments for why TBTF is a problem are many and compelling. One reason is that competition in the financial market is destroyed, or at least seriously distorted. There are two parts of this particular problem. One is “moral hazard”. We have a “moral hazard” situation when one decides what risks will be taken and someone else pays what it costs if that risk materializes. A TBTF bank knows that even if everything goes wrong, the bank will survive because the taxpayers will rescue it. Thus, it can engage in risk-heavy business that a competitor outside the TBTF circle would not engage in because the margins are too small or the risk too high. The second part of the problem is more robust. Since investors know that the TBTF banks will be bailed out by the politicians should a major problem occur, they are prepared to invest their money in these institutions for lower yields than if, all else being equal, the money would be put into a non-TBTF bank. Investors simply accept a lower risk premium. In other words, the TBTF banks can raise the money they need more cheaply than other banks. According to some estimates (see Johnson & Kwak, 2010), the U.S. TBTF banks today have on average a competitive edge in funding in relation to other financial institutions of 0.78 percentage points – “a huge financial advantage” as Simon Johnson and James Kwak  write in their book, 13 Bankers.

That the competition in the financial market is distorted is reason enough, one might think, to vigorously address the TBTF problem. However, there are two even more fundamental problems. It’s no exaggeration to say that TBTF is a threat to the efficient functioning of the market economy, and thus to capitalism. There are a number of ground rules that must be met for a market economy to function reasonably well. One of the most important of these rules is “free entry and exit”. For example, this means that a company that cannot survive the competition must be able to exit the market quickly; in other words, go bankrupt. In reality, the main stakeholders in the failing company, the owners and top management, lose all their money and influence.

TBTF turns this principle upside down, at least judging from what one has seen happening in the United States. The owners and, even more remarkably, top managements of the TBTF banks seem to have gone through the last financial crisis with minimal injuries, with a couple of exceptions. Lehman Brothers went bankrupt, and Bear Stearns’ shareholders were forced to sell their shares at a very low price. But the rest of the TBTF banks continue as if nothing remarkable happened. In some cases the same people remain on the banks’ top management teams as during the crisis. They continue their risky activities in terms of proprietary trading and grant themselves the same huge bonuses as before the crisis.

It’s provocative that it’s allowed to happen, especially in the United States with its highly developed sense of what a well-functioning market economy requires. Again, “free entry and exit” is one of the most basic principles of a functioning capitalism. Arguably, letting the TBTF banks break this principle will prove to be a very costly political failure.

The third problem is that the TBTF banks distort the political balance of power. The classic image of a well-functioning “division of labor” between the political system and business, and that includes banks, is that politicians are responsible for the general rules of game, laws and regulations, for supervision and for the system of sanctions when the rules are violated. Business on the other hand has, within this framework of laws and regulations, the responsibility to produce the goods and services demanded by the market as efficiently as possible. This is in theory. In practice, the boundary between the two spheres is blurred to say the least. In all democracies, market participants, and especially the large corporations and their lobbying organizations, do all they can to try to influence the legislators to their advantage. The TBTF banks play this power game to the hilt.

Serious analysts (Simon Johnson is one of them, Joseph Stiglitz another, Paul Krugman a third) can credibly demonstrate that Wall Street, which in practice is equivalent to the TBTF-banks, has such a strong lobbying force in Washington today that it basically can get the legislation it wants. The reason is a mix of big money to the political parties and individual politicians, vast lobbying resources, and people in key positions in government, close to the president, who “understand” Wall Street (Geithner, Bernanke, Summers et al.). Their lobbying power is reinforced by the U.S. value-based fear of “government”.

What will the long-term consequences be? No one can say anything for sure about that today, but one trend is clear. The TBTF banks are currently so economically and politically powerful that they become “self-contained” in a whole new way. They no longer seem to have to worry about what others think. One sign of this is how they deal with their bonus payments. Although just a couple of years ago these banks were bankrupt, even though they survived thanks to the taxpayers who bailed them out, and despite loud opposition to the bonus culture by the general public and in the political circles in Washington, the large Wall Street banks continue to pay extremely high bonuses to their employees. During the first half of 2009, Goldman Sachs put an unimaginable $11.4 billion, or $750,000 per employee, in a pot for salaries and bonuses. One can discern a kind of “crony capitalism”, the same type of capitalism that historically has existed in many developing countries. It permits the companies and owners with good contacts with the president and his family to benefit at everybody else’s expense. Of course the TBTF-related problems are specific, and United States is a highly developed country, but the basic pattern of crony capitalism, a group of companies and executives that are living on particularly advantageous terms, is the same.

A huge political mistake

Today TBTF is primarily a U.S. problem. This may seem strange; there are large banks in other Western countries that politicians might be forced to bail out in a crisis. These banks are also TBTF. However the U.S. situation is special. This is due to the absolute size of the U.S. TBTF banks, but also to how the rescue operations during 2008 and 2009 were designed. U.S. politicians rescued the largest banks without using the classic rulebook as to which owners and top executive management have to pay the full costs (i.e. lose their money and positions). Because they didn’t “strike while the iron is hot”, the politicians failed to make the changes in ownership and management of the big banks that should have been made. Or expressed another way, they did not do as Gordon Brown and the British government did during the recent crisis, and as the Swedish politicians did in the early 1990s during the Swedish financial crisis, let the state take over the full ownership of the failing banks, replace top management, clean up the business, and then re-privatize. That something of the sort didn’t happen in the U.S. in 2008-2009 was a huge political mistake.

Why didn’t American politicians do what their colleagues in England and Sweden did? Some politicians in Washington, even a number of economists and political pundits, thought the “Swedish model” was worth emulating. Bo Lundgren, finance minister in the Swedish government during the crisis in the 1990s, was even summoned to Congress for hearings in the spring of 2009. However, it was a hearing at a low level, and according to the New York Times there wasn’t a genuine and broad interest in either of the two major parties in an arrangement with, as in Britain and Sweden, a government takeover of the failed banks and a tough bailout.

It’s reasonable to assume that the political disinterest in Washington basically had to do with values. It would have been too great a departure from American libertarian ideals to use federal resources to take over the ownership of the bankrupt banks. It would have been called “socialism”, giving up on the “small government” approach. The price for being ideological can be very high. In this case, the “moral hazard” problems in the U.S. financial market are in danger of becoming gigantic. And even more important is that one of capitalism’s fundamental principles – exit – is eliminated in an important sector of the economy, and that the TBTF banks through formidable lobbying power can influence the decision makers in Washington to an alarming extent. Can things get much more serious?

Literature:

Acharya, VV & Richardson, M. (ed.), 2009, Restoring Financial Stability, John Wiley & Sons, Inc., Hoboken, New Jersey;

French, KR et al, 2010, The Squam Lake Report, Fixing the Financial System, Princeton University Press, Princeton;

Johnson, S. & Kwak, J., 2010, 13 Bankers, The Wall Street Takeover and The Next Financial Meltdown, Pantheon Books, New York;

Krugman, P., 2009, The return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, New York;

Rebonato, R., 2007, Plight Of The Fortune Tellers, Why We Need to Manage Financial Risk Differently, Princeton University Press, Princeton;

Roubini, N. & Mihm, S., 2010, Crisis Economics, The Penguin Press, New York;

Stiglitz, JE, 2009, Free Fall, W.W. Norton & Company, New York;

First published (in Swedish): September 7, 2010