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September 20, 2009 Op-Ed Contributors

The Recession Is Over — for Now (or is it??)
By PETER BOONE and SIMON JOHNSON

SPEAKING at the Brookings Institution last week, the chairman of the Federal Reserve, Ben Bernanke, remarked that the recession in the United States is “very likely over.” He’s surely right that a recovery is under way; in fact, the short-term bounce back may actually turn out to be faster than he thinks — rapid growth is not uncommon right after a severe financial crisis.

Mr. Bernanke commands great respect because of his impressive efforts to head off financial collapse, but his speech was deeply worrisome on the bigger questions: what caused the financial crisis, and how can we prevent another such calamity?

Mr. Bernanke still refuses to acknowledge the Fed’s role in creating financial boom-bust cycles, and therefore his diagnosis and solutions sound overly technocratic and somewhat hollow. He has called for requiring banks to hold more liquid assets and increase their equity cushions, and passing legislation that would permit the Fed to effectively close large financial institutions when they are failing. He also wants the Fed to be responsible for regulation of such large banks.

But none of this is enough. Why should we believe that the Federal Reserve could regulate banks and avert financial bubbles when that agency has repeatedly failed to do so over the past 30 years? (it is actually almost 100 years -- the Fed took over in 1913 -- mrc)

The greatest failure of all time happened from 2002 to 2007, and for most of that time Mr. Bernanke was on the Fed’s board of governors. To make financial regulation workable again, the chairman needs to admit the institution’s recent failures and call for deeper reforms in the operation of the Fed to make financial regulation workable again. Otherwise, the United States and the rest of the world are being set up to face another — much larger — financial crisis. As someone who came to government from academia rather than banking, Mr. Bernanke is not beholden to business, and that puts him in a good position to make the kind of basic changes to the culture of regulation that are most needed — in particular, changes that would stop so many regulators from moving back and forth into the finance industry.

He is also a student of the history of the Fed and knows how, after 1934, his predecessor Marriner Eccles helped lead a redesign of the financial system that served America well for 50 years. So he should also realize that if he truly wishes to end our cycles of boom and bust, he needs to fight for a stronger regulatory system and against the powerful financial interests that encourage policy makers to avoid real reform. In successive financial boom-busts over the past 30 years, the Fed undertook smaller versions of what Ben Bernanke did over the past 12 months. In the Latin American debt crisis of 1982, the savings-and-loan crisis of the late 1980s, the Asian financial crisis and the collapse of Long-Term Capital Management in 1998 and during the bursting of the dot-com bubble in 2001, you saw the same pattern: First, of course, the financial system grew rapidly, bank profits were large and a bubble emerged. At a certain point, we reached the market peak and stared down the mountain. Bankers frantically called the Fed, and it dutifully stepped in to prevent an economic collapse — by lowering interest rates and providing credit to “maintain liquidity.”

In his speech last week, Mr. Bernanke indicated that interest rates are now likely to stay low for a long time. That means that if you are running a major bank, you have good reason now to take on more “leverage” (debt). If collapse threatens again, bank executives know the Fed will support them. And lenders know that it is a far better risk to make loans to banks supported by the Fed than to firms that can go bankrupt, like automakers or high-technology companies. All of this facilitates a short-term recovery, of course, and is the cornerstone of Mr. Bernanke’s strategy. But it also feeds a new financial frenzy — making it harder to sustain real growth, and also making it less likely that a broad cross section of society will benefit.

There is nothing wrong with having the Federal Reserve in place to deal with financial shocks. This was the original idea that emerged from the 1907 financial crisis, and from the subsequent National Monetary Commission reports — that the United States needed a central bank to manage downturns. At that time, Democrats were rightly suspicious that the commission, led by Senator Nelson Aldrich, Republican of Rhode Island, was looking for a way to give private banking interests influence over federal money. When it was created in 1913, the Federal Reserve was meant to be a compromise — a way for private bankers to have a say in the operation of the national bank but also a way for the government to keep private bankers in check. And that is how it worked from 1935 to 1980, when the Fed and other agencies ensured that banks’ activities did not put the public purse at risk. Both before 1935 and again after 1980, however, the Fed’s financial regulation was and has been weak.

At the heart of this weakness are the large profits that can be earned by taking advantage of lax regulation in the financial sector. The phenomenal growth of the derivatives market over the past 30 years, for example, has made all our big banks far more interconnected, and hence systemically risky; if one bank falls the others fall with it. Yet our regulators, many of whom remain in office today, watched as this time bomb grew and then exploded with the collapse of the American International Group.

Since our top regulators are political appointees, it should be no surprise that, in the face of heavy lobbying by the financial sector, they often turn out to be regulatory doves. We’ve permitted our mid- and high-level regulators to revolve between jobs in finance and officialdom. To name just two examples, during the Clinton administration, Robert Rubin left Goldman Sachs to become secretary of the Treasury, then returned to the industry to take an oversight role at Citigroup, while Henry Paulson, the secretary of the Treasury during the last years of the George W. Bush administration, came straight to government from Goldman Sachs.

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector. These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes. When the Federal Reserve inevitably bails banks out, it receives great applause (particularly from the financial sector).. Yet with each cycle of failure and bailout, the financial system grows ever larger and more dangerous.

Not all of this, of course, is under Ben Bernanke’s control. Like Alan Greenspan before him, when he provides bailouts and facilitates recovery, Mr. Bernanke can say he is only doing his job. But the true and original responsibility of the Fed is much broader that that. The central bank is supposed to prevent crises that threaten to bankrupt the country. In today’s nascent global recovery, we are already seeing bubble-like rises in the prices of real estate and assets, from Hong Kong and Singapore to Brazil. And many more emerging markets will likewise soon boom. The details of who makes which crazy loans to whom will no doubt be different from what they were from 2002 to 2007, but the basic structure of incentives in the system is unchanged.

The same people are running the American banks, and the same regulators are regulating them, so you can easily get the same outcome here as we have just seen.

We should prohibit companies and senior managers in regulated financial industries from making donations to political campaigns. We should also restrict public employees involved in regulatory policy from working in those industries for five years after they leave office.

And we should prohibit people who move to government from the finance sector from making policy decisions on bailout and regulatory-related matters for a minimum of five years.

Our regulators need to be smart people who understand finance, but they don’t need to be drawn from the upper echelons of the financial industry.

There are many proven, dedicated professionals in our regulatory agencies today, and we should support the development of an even stronger cadre of career regulators.

It should be up to the financial sector to make its practices clear and simple enough for these professionals to understand, and any that are too complex should not be approved.

Finally, we should significantly raise capital requirements for the financial sector — and the bigger the bank, the more capital you should need. (Of course, this would discourage banks from growing too large.) The Obama administration should at least triple the current requirements.

A comment from Martin R. Carbone follows.

In my humble opinion, one of the biggest problems with our Banking and Money systems is the fact that they are sheltered from true competition by hidden rules and regulations. In general no new banks are allowed by the Federal Reserve. Read the following which is copied from << http://www.primeronmoney.com/chapters/chapter8.html >>) which was taken from Wright Patman's 164 book "A Primer On Money" -- printed by the U.S. Government Printing Office in 1964.

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HOW THE FEDERAL RESERVE GIVES AWAY PUBLIC FUNDS TO THE PRIVATE BANKS Private banks enjoy a very special relationship ‘with the Federal Government. After all, most business firms employ private capital or privately owned resources to produce a product or provide a service which can be profitably sold in the marketplace. Most business firms pay for the raw materials and services they receive, and, furthermore, in the case of most kinds of business firms, the business itself is a risk-taking venture. The firm succeeds or fails in competition with other business firms. But the conditions under which private banks operate are very different. In the first place, one of the major functions of the private commercial banks is to create money. A large portion of bank profits come from the fact that the banks do create money. And, as we have pointed out, banks create money without cost to themselves, in the process of lending or investing in securities such as Government bonds. Bank profits come from interest on the money lent and invested, while the cost of creating money is negligible. (Banks do incur costs, of course, from bookkeeping to loan officers’ salaries.) The power to create money has been delegated, or loaned, by Congress to the private banks for their free use. There is no charge. On the contrary, this is but one of the many ways the Government subsidizes the private banking system and protects it from competition. “Check clearing” is one of the services; i.e., the collection and payment of funds due one bank from another because of depositors’ use of their checkbook money. The costs of this service alone runs into scores of millions of dollars. The gross expenses of the combined Federal Reserve banks totaled $207 million in 1963, most of which was incurred as a cost of providing free services to the private banks. Other Federal agencies also receive services from the Federal Reserve. But these are not free. The System received about $20 million for “fiscal agency and other expenses” in 1963. In addition, the Federal Government provides private banks with a large measure of protection from competition, and the hazards of failure. For example, when a group of business people wish to enter the banking business by opening a national bank, the Federal officer in charge of such matters will not issue a charter, or license, before his office has made studies and surveys to determine whether the proposed bank meets certain “standards.” One “standard” is that the Comptroller of the Currency must be satisfied that (a) the new bank will succeed, and that (b) it is not likely to cause any already existing bank to fail, or even to “weaken” substantially any already existing bank. This means, in brief, that nobody can enter the banking business by opening a national bank, unless the proposed bank is to be located where it will not cause an inconvenient amount of competition to other banks already in business. If a group wishing’ to enter the banking business is refused a national bank charter, the group may, of course, apply to State banking authorities for a charter to be a State bank. But State banking boards are pretty much like the Comp-troller of the Currency: they tend to make sure that a new bank will not encounter strong enough competition to weaken itself or weaken the banks already in business. As a practical matter, it is almost impossible to enter the banking business and attract depositors unless the bank can obtain deposit insurance from the Federal Deposit Insurance Corporation. Not many depositors are willing to keep funds in banks without FDIC insurance. The Federal Deposit Insurance Corporation is, of course, another Federal agency. So, in practice, even where a State banking authority is willing to issue a charter for a new State bank, a Federal agency has the last word regulating “undue” competition. People who go into the grocery business, or the farming business, or almost any other kind of business, enjoy no such protection from competitors coming in and taking over a share of their market, or even squeezing them out of business. Federal law provides the banking business with still another kind of protection from competition. This is the Federal law which makes it unlawful for most banks to pay their depositors any interest on demand deposits. Before this law was passed, commercial banks used interest payments to compete for demand deposits specially those of large accounts, and these depositors tended to move their checking accounts to the bank paying the highest interest rate. Aside from subsidies and :protection against competition, the Government nourishes the banks ill a third way, through FDIC insurance. Because of this insurance, many depositors are willing to leave funds in the bank, which they would otherwise hoard in lockboxes or in other places outside the banks. The existence of this insurance means, then, that a larger portion of the money supply at any given time is in the form of bank deposits and a smaller portion is ill the form of currency and coin than would otherwise be the case. Money in the form of currency and coin makes no profit for the bank, but money in the form of deposits does. And then, of course, there are the indirect subsidy features of the FDIC program explained in the last chapter: insufficient premiums, free recourse to the Treasury for $3 billion and the general protective umbrella provided by the Government’s ultimate backing. Why all this direct Federal aid to the private commercial banks ~ Does this result from a self-assumed obligation to assure profits for the bank ~ Not at all. The primary purpose of the aid is to assure the general public good banking services and a good money system, both of which are recognized as indispensable to trade and commerce in a modern economic system. True, bank profits for the bankers are necessary for a good banking system. But bank profits are only a means toward furthering the general public interest.

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In my opinion, any increase in Capital Requirements would certainly tend to make the banking business even less competitive -- (from above) One “standard” is that the Comptroller of the Currency must be satisfied that (a) the new bank will succeed, and that (b) it is not likely to cause any already existing bank to fail, or even to “weaken” substantially any already existing bank. -- and that would be terrible. It would practically guarantee that the system will never change(mrc).

Our financial system provides valuable services to the public, but it also poses serious risks. If we can’t re-regulate more strongly to better protect public funds, the next crisis could be worse than the last one.

Peter Boone is the chairman of Effective Intervention, a British charity, and a research associate at the London School of Economics’ Center for Economic Performance.

Simon Johnson is a professor at the M.I.T. Sloan School of Management and a senior fellow at the Peterson Institute for International Economics.