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Simon Johnson on Obama’s Achilles Heel
By Eric Uhlfelder
June 9, 2009

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Simon Johnson

While he agrees with much of what the US administration is doing to confront the economic crisis, Simon Johnson, the former chief economist of the International Monetary Fund, fears that present policy is not addressing a key issue: the overwhelming influence of the finance industry in US economic affairs.  He likens this imbalance to what we see at the core of many emerging markets crises.  And Johnson thinks recovery can’t succeed unless the administration breaks the financial oligarchy that is sustaining the status quo and preventing essential reform.  Without such reform, he warns things could get much worse.

We caught up with Johnson to get his take on the financial crisis and to see what he thinks lies ahead for the US economy.

What surprised you the most about the financial crisis?

“We should be very skeptical about what we hear from all officials and experts, and of course that applies to me as well.  I think we have learned that we don’t know nearly as much as we thought we did about the functioning of financial markets and how they can get into trouble.”

When I was chief economist at the IMF in the spring of 2007, the fund expressed some serious concerns about deteriorating economic conditions.   Leaders of the G7 assured us that everything was under control. These people included under secretaries of Treasury, deputy ministers, and deputy central bank governors.   Then, as the financial markets began to seize up in early August of the same year, I was shocked by how unprepared the G7 was.

What does this tell you about these leaders?
 
I think that everyone, including myself, bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed. So I really can’t point too much of a finger at the G7.  They certainly weren’t alone in being caught unaware .

Given that acknowledgement, how can investors feel confident with what officials are telling us today?

That’s a great question.  We should be very skeptical about what we hear from all officials and experts, and of course that applies to me as well.  I think we have learned that we don’t know nearly as much as we thought we did about the functioning of financial markets and how they can get into trouble.

Do you feel confident the policies that have been put in place will actually work?

Let’s divide the assessment between broad economic issues and dealing with the banks, which largely got us into this mess.  I like what the US administration has done in its mixed bag approach.  It makes sense that if you’re not sure what will work, you try a bit of everything: you have some fiscal stimulus, you have some support of housing, and you try to act on the banking front.  To my way of thinking, they have been a little overweight weight on the fiscal stimulus. I would have been a bit more evenly balanced. 

For certain, I think the administration has been far too deferential to the big banks, trying to bend over backwards not to really annoy or harm their interests.  This is a fairly substantial disagreement I have with the administration.  Overall, however, I think the administration has done a much better job than the last one in putting together a package that has a chance of turning things around.

“I think the administration has been far too deferential to the big banks, trying to bend over backwards not to really annoy or harm their interests.  This is a fairly substantial disagreement I have with the administration.“
But there could be an Achilles heel, and it’s likely to be the banking system.  That’s where many distressed economies often get into trouble.  We’ve seen even when a lot of good policies were in place that if you’re not fixing the banking system up front--that is to say, if you don’t recapitalize it sufficiently, and you don’t replace the people who got you into trouble in the first place--then those deficiencies could work against everything else you’re doing.


Why hasn’t the government been more firm with the banks?

The reason the government gives is that it’s concerned stricter demands would further damage the banking system, which will cause additional problems for the economy.  Behind that kind of logic is the belief that big finance is important and good for the economy, and you need to support financial intermediation with whatever means you have during a crisis like this.  But if a troubled third-world nation was making this kind of argument, we would regard it as a mistake, and I think it is a mistake here too.

That said, it is possible that banks could avoid having to write -off every bit of toxicity, avoid wiping out equity holders, and have debt holders take a substantial hair cut by earning their way of out the crisis.  In this way, they could replenish their capital bases. 

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